Energy Trading {Unit 05}

8/14/2019 Energy Trading {Unit 05}

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Unit-5

Petroleum Trading Strategies

Crack Spread

The word "spread" is generally used in the financial industry to refer to the difference

between two related entities that can be expressed quantitatively while the word "crack"

is used in the oil refining industry as a verb describing the process of separating and

transforming the various chemical components of crude oil into saleable refined

products. Thus the term "crack spread" refers to the spread, or margin, that a refinery

can earn by cracking a barrel of oil into refined products.

One of the most important factors affecting this spread is the relative proportions of the

products produced by a refinery. There is a wide range of such products which can

include gasoline, kerosene, diesel, heating oil, aviation fuel, asphalt and various others.

To some degree, the mix of these products can be varied in order to suit the demands

of the local market. Regional differences in the demand for each refined product depend

upon the relative demand for fuel for heating, cooking or transportation purposes. Within

a region, there can also be seasonal differences in demand for heating fuel versus

transportation fuel.

The mix of refined products is also affected by the blend of crude oil feedstock

processed by a refinery and by the capabilities of the refinery. Heavier crude oils

contain a higher proportion of heavy hydrocarbons composed of longer carbon chains.

As a result, heavy oil is more difficult to refine into lighter products such as gasoline. A

refinery using less sophisticated processes will be constrained in its ability to optimize

its mix of refined products when processing heavy oil.

One of the primary goals in managing a refinery is optimizing the mix of refined products

given the supply and demand constraints of the local market. These constraints are

expressed by relative differences in the local prices of both refined products and


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available feed stock. By adjusting its product mix to take advantage of local price

differentials, a refinery can optimize its crack spread.

For integrated oil companies that control their entire supply chain from oil production to

retail distribution of refined products, there is a natural economic hedge against adverse

price movements. For independent oil refiners which purchase crude oil and sell refined

products in the wholesale market, adverse price movements can present a significant

economic risk. Given a target optimal product mix, an independent oil refiner can

attempt to hedge itself against adverse price movements by buying oil futures and

selling futures for its primary refined products according to the proportions of its optimal

mix.

For simplicity, most refiners wishing to hedge their price exposures have used a crack

ratio usually expressed as X:Y:Z where X represents a number of barrels of crude oil, Y

represents a number of barrels of gasoline and Z represents a number of barrels of

distillate fuel oil, subject to the constraint that X=Y+Z. This crack ratio is used for

hedging purposes by buying X barrels of crude oil and selling Y barrels of gasoline and

Z barrels of distillate in the futures market. The crack spread X:Y:Z reflects the spread

obtaining by trading oil, gasoline and distillate according to this ratio. Widely used crack

spreads have included 3:2:1, 5:3:2 and 2:1:1.[1] As the 3:2:1 crack spread is the most

popular of these, widely quoted crack spread benchmarks are the "Gulf Coast 3:2:1"

and the "Chicago 3:2:1".

Various financial intermediaries in the commodities markets have tailored their products

to facilitate trading crack spreads. For example, NYMEX offers virtual crack spread

futures contracts by treating a basket of underlying NYMEX futures contracts

corresponding to a crack spread as a single transaction.[2] Treating crack spread futures

baskets as a single transaction has the advantage of reducing the margin requirements

for a crack spread futures position. Other market participants dealing over the counter

provide even more customized products.


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The following discussion of crack spread contracts comes from the Energy Information

Administration publication Derivatives and Risk Management in the Petroleum, Natural

Gas, and Electricity Industries:[3]

Refiners profits are tied directly to the spread, or difference, between the price of crude

oil and the prices of refined products. Because refiners can reliably predict their costs

other than crude oil, the spread is their major uncertainty. One way in which a refiner

could ensure a given spread would be to buy crude oil futures and sell product futures.

Another would be to buy crude oil call options and sell product put options. Both of

those strategies are complex, however, and they require the hedger to tie up funds in

margin accounts.

To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX

treats crack spread purchases or sales of multiple futures as a single trade for the

purposes of establishing margin requirements. The crack spread contract helps refiners

to lock-in a crude oil price and heating oil and unleaded gasoline prices simultaneously

in order to establish a fixed refining margin. One type of crack spread contract bundles

the purchase of three crude oil futures (30,000 barrels) with the sale a month later of

two unleaded gasoline futures (20,000 barrels) and one heating oil future (10,000

barrels). The 3-2-1 ratio approximates the real-world ratio of refinery output2 barrels

of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and

sellers concern themselves only with the margin requirements for the crack spread

contract. They do not deal with individual margins for the underlying trades.

An average 3-2-1 ratio based on sweet crude is not appropriate for all refiners, however,

and the OTC market provides contracts that better reflect the situation of individual

refineries. Some refineries specialize in heavy crude oils, while others specialize in

gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that

the traders portfolio is close to the exchange ratios. Traders can also devise swaps that

are based on the differences between their clients situations and the exchange

standards.


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Spread trades

Spread positions offer another way of using futures. There are many types of spreads,

but they all have two things in common. First, a spread always involves at least two

futures positions, which are maintained simultaneously. For example, a trader may be

long 10 June NYMEX contracts and short 10 September NYMEX contracts. Second, the

price changes in the two or more legs of the position are expected to have a reasonably

predictable relationship and the potential profitability of the spread lies in that

relationship or expected changes to that relationship. For example, the trader who is

long 10 June contracts (the near-term contract) and short 10 September contracts (the

distant contract) will benefit if market forces cause the near-term contract to make a

larger advance than the more distant contract - or if market forces cause the distant

contract to drop more sharply than the near-term contract.

Crack Spreads contract

NYMEX launched the crack spread contract in 1994. NYMEX treats crack spread

purchases or sales of multiple futures as a single trade for the purposes of establishing

margin requirements. The crack spread contract helps refiners to lock in a crude oil

price and heating oil and unleaded gasoline prices simultaneously in order to establish a

fixed refining margin.

A petroleum refiner, like most manufacturers, is caught between two markets: the raw

materials he has to purchase and the finished products he offers for sale. It is the nature

of these markets for prices to be independently subject to variables of supply, demand,

transportation, and other factors. This can put refiners at enormous risk when crude oil

prices rise while refined product prices stay static or even decline, thus narrowing the

spread. The Exchange facilitates crack spread trading in its futures trading rings by

treating them as a single transaction for the purpose of determining a market

participant's margin requirement.

To calculate the theoretical refining margin, first calculate the combined value of

gasoline and heating oil, and then compare the combined value to the price of crude.


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Since crude oil is quoted in dollars per barrel and the products are quoted in cents per

gallon, heating oil and gasoline prices must be converted to dollars per barrel by

multiplying the cents per gallon price by 42 (there are 42 gallons in a barrel). If the

combined value of the products is higher than the price of the crude, the gross cracking

margin is positive. Conversely, if the combined value of the products is less than that of

crude, then the cracking margin is negative.

Using a ratio of two crude to one gasoline plus one heating oil, the gross cracking

margin is calculated as follows:

(Assume heating oil is $2.00 per gallon, gasoline is $2.20per gallon and crude is $75.00 per barrel.)$2.00 per gallon x 42 = $84 per barrel of heating oil$ 2.20 per gallon x 42 = $92.4 per barrel of gasoline

The sum of the products is: $176.4Two barrels of crude ($75 x 2) = $150.00Therefore, $176.4- $150.00 = $26.4$26.4/2 = $13.2 (margin)A refiner expects crude prices to hold steady, or rise somewhat, while products will fall.

In this case, the refiner would "sell the crack"; that is, he would buy crude futures and

sell gasoline and heating oil futures.

Conversely, buying the crack means buying gasoline and heating oil and selling crude.

Whether a hedger is selling the crack or buying the crack reflects what is done on the

product side of the spread. Once the hedge is in place, the refiner need not worry about

movements in absolute futures prices. He need be concerned only with how the

combined value of products moves in relation to the price of crude.

Crack Spread options

Crack spread options are designed to protect the refining margin, while at the same

time allowing refiners and other market participants to take advantage of favourable

changes in the spread, the only cost being that of the upfront premium. Hedging crackspreads with future locks a market participant into a differential which may require him

to relinquish a favourable market move in return for price stability. In other words crack

spread options complement the futures by allowing the refiners to hedge its operating

margin at a known up - front cost while simultaneously allowing it to participate in any

future widening of refining margins. The options give added flexibility to those trying to


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manage their risk in increasingly fickle physical market. Crack spreads are designed to

protect the refining margins, or differential, of gasoline or heating oil to crude oil, not the

absolute level of prices. While crude- to- product ratios of future crack spreads are

tailored by traders to best fit their needs, Crack spread options contracts are

standardized exchange instruments which reflect one to one ratio.

Crack spread options offer a number of benefits:

Refiners, Blenders, and marketers have a flexible hedge against variable refining

margins in heating oil and gasoline.

Puts give refiners an instrument for locking in crude cost and product margins

without penalty to further market gains.

Calls afford product marketers protection during unstable spread increases.

Crack spread options in general furnish traders with an efficient mechanism for

hedging the changing relationship between crude and products.

They allow refiners to generate income by writing options

Refiners margin could be hedged by utilizing the appropriate future contracts,

but maintaining the hedge essentially locks him into a predetermined margin. Options

give him the right, but not the obligation, to obtain that margin.

Calendar Spread Options

NYMEX offers calendar spread options on crude oil, heating oil, and unleaded gasoline

Buying a call on the calendar spread options contract will represent a long position

(purchase) in the prompt months of the futures contract and a short position (sale) in the

further months of the contract. Thus, the storage facility can buy a call on a calendar

spread that will allow it to lock in a storage profit or to arbitrage a spread that is larger

than its cost of Storage. Storage facilities play an important role in the crude oil and

refining supply chain. Facilities near producing fields allow the producers to store crude

oil temporarily until it is transported to market. Facilities at or near refining sites allow

refiners to store crude oil and refined products. Heating oil dealers build inventories

during the summer and fall for winter delivery. Natural gas storage facilities allow


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producers to inject excess supply during shoulder months for withdrawal during peak

demand months and provide producers with the convenience of a shortened injection

and withdrawal cycle (a day or a few days), giving the producers and traders the ability

to capitalize on the differential between forward prices and spot prices.

For most non-energy commodities, the cost of storage is one of the key determinants of

the differential between current and future prices. Although storage plays a smaller role

in price determination in some energy markets. It can be important for heating oil and

natural gas.

For example, natural gas prices in the winter months could be established by the prices

in the preceding shoulder months plus storage expenses and an uncertainty premium to

account for the possibility of a colder than normal winter. If the price differential between

winter months and shoulder months substantially exceeds storage expenses, traders

can buy and store gas and sell gas futures. Such arbitrage tends to narrow the price

differential.

If the market is in backwardationi.e., when the prices for prompt months are higher

than the prices for further monthsstorage facilities with excess capacity cannot

arbitrage the calendar spread. In this case, storage facilities can sell put options on

calendar spreads to earn income from the option premium. The buyer of a calendar

spread put option, when the option is exercised, will receive a short position (sale) in the

prompt months of the futures contract and a long position (purchase) in the further

months of the contract. Thus, if the storage facility that sold (wrote) the put option is

forced to accept delivery because the buyer has exercised the option, it will receive a

long position in the prompt futures and a short position in the further futures.

Volumetric Production Payment Contracts

A volumetric production payment contract(VPP) is both a prepaid swap and a synthetic

loan. Unlike a normal swap, where the differences between the fixed and variable


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payments are periodically settled in cash, the buyer (usually a producer) is paid the

present value of the fixed payments in advance. In exchange, the seller receives an

agreed-upon amount of natural gas or other product over time.

These deals typically last for 3 to 5 years. VPPs have been purchased by natural gas

producers in the past, and in some cases they appear to have been used in project

finance. In function, VPPs are identical to loans paid off with product.

The obvious problem with VPPs is that the seller, usually an energy trader, invests a

large amount in advance, risking both buyer default and adverse price movements In

addition, VPPs can be used in place of loans to hide debt. What Enron and others often

did was to find users of the product who were willing to pay up front in exchange for a

price guarantee, use part of those payments to make the advance payment on the VPP,

and then hedge their price risks by securing guarantees in the event of default.

Paper Refinery

This is the relationship between refinery margins traded on paper using petroleum

futures (the paper refinery) and the physical trade of crude oil into the US.

Computations of a 3:2:1 crack spread were constructed using daily observations of

second- and third-nearby unleaded gasoline and heating oil futures contracts traded onthe New York Mercantile Exchange (NY MEX) and spot Brent crude oil prices. The

crack spread represents the margin between the cost of crude oil feed stock today and

the value of the products produced by a refinery in the future. Unit root tests on each of

the time series found crack spreads to be stationary while crude oil imports were found

to be non-stationary. A s the two series were found to be integrated of different order,

co-integration analysis of the two series was not deemed appropriate. Instead, linear

relationships between crack spreads and imports were examined using causality tests.

It was found that the 2-month 3:2:1 crack spread Granger-causes crude oil imports and

that this causality is unidirectional. The significance of these findings lies in the fact that

other industries like tanker shipping derive their demand from the demand for, and trade

in, petroleum. Crack spreads, therefore, can provide a leading indicator for short term

developments in tanker demand. For a chartering manager who has ships on the spot


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market, crack spreads can help him/her anticipate demand developments and influence

vessel deployment and chartering decisions.

Strategy based on Price Volatility

In finance, a straddle is an investment strategy involving the purchase or sale of

particular option derivatives that allows the holder to profit based on the magnitudeof

price movement in the underlying security, regardless of the directionof price

movement.

Long Straddle

A long straddle involves going long (i.e. buying) both a call option and a put option on

some stock, interest rate, index or other underlying. The two options are typically boughtat the same strike price and expire at the same time. The owner of a long straddle

makes a profit if the underlying price moves a long way from the strike price, either

above or below. Thus, an investor may take a long straddle position if he thinks the

market is highly volatile, but does not know in which direction it is going to move.


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For example, company XYZ is set to release its quarterly financial results in two weeks.

A trader believes that the release of these results will cause a large movement in the

price of XYZ's stock, but the trader does not know whether the results will be positive or

negative, and so does not know in which direction the price will move. The trader can

enter into a long straddle, where a profit will be realized no matter which way the price

of XYZ stock moves, so long as the magnitude of the movement is sufficiently large in

either direction. If the result is positive enough, the call option will be exercised and put

option ignored. If the result is negative enough, the put option will be exercised and call

option ignored. If the result doesn't fluctuate enough, loss occurs.

Short Straddle

Conversely a short straddle is, in a contrasting position, i.e. going short (selling) both

options. The investor makes a profit if the underlying price is close to the strike at

expiration. Thus, the investor thinks the markets are unlikely to move much between

purchase and expiry of the options. A short straddle position is highly risky, because the

potential loss is unlimited, whereas profitability is limited to the premium gained by the


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initial sale of the options. The Collar is a more conservative "opposite" that limits gains

and losses.

As a Volatility Strategy

By engaging in a straddle transaction, the investor is also taking a position on the

volatility of the underlying security. Going long a straddle is a bet that the underlier will

be more volatile over the straddle's term than predicted by the market. Conversely,

going short a straddle is a bet that the underlier will be less volatile. To see this, assume

that the investor frequently re-hedges his portfolio with the underlier to keep his portfolio

delta neutral. Because delta for an option is a monotonically increasing function of the

underlier's price, one can quickly see that large underlier movements help the investor

who is long a straddle. When the underlier's price goes up, the total delta of the straddle

goes up as well, and the investor will need to sell the underlier to maintain a delta

neutral portfolio. When the underlier goes down, the investor will need to buy the

underlier. Hence, lots of movement in the underlier, or volatility, causes the investor to

gain from his hedging transactions - he will always need to buy when the underlier is

low and sell when high. In the same way, an investor with a short straddle will face the

opposite situation - he will have to buy high and sell low when the underlier's price is

moving. For investors with a view on the future volatility of a particular underlier, a

straddle (or, for that matter, any option in general) can be a way to implement that view.

For a further discussion of this style of investing, see volatility arbitrage.

An option spread is a position comprising two or more options

on the same underlier. Some spreads have standard names. A straddle comprises a

put and a call with the same expiration and struck at the same priceusually at the

money. Long and short straddle payoffs are depicted in Exhibits 1&2


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Payoff of a Long Straddle

Exhibit 1

A long straddle is a bet on high volatility. Itmakes money if the underlier value moves

significantly either up or down.

Payoff of a Short Straddle

Exhibit 2

A short straddle is a bet on low volatility. It

makes money as long as the underlier value

does not change too much.


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Long Butterfly

A Long Butterfly is a Short Straddle with a conservative twist! By purchasing two out-of-the-money options (one Put and one Call) the investor's maximum risk exposure

becomes definable.

When to use

As was the case with the Short Straddle, the investor should select this position only if

XYZ is expected to trade within plus-or-minus 5% of $60 over the next 90 days. By

buying the two options, the straddle's risk has been capped, but the range of profitability

has been reduced.

Risk/Reward Characteristics

Unlike the Short Straddle, this strategy has limited risk. It can be viewed as being short

one 60-65 Call Vertical and short one 55-60 Put Vertical. It's maximum potential profit

point is at the strike price ($60) at expiration, and it is equal to the spread's initial credit.

Most of profit develops in the last month because of rapid time decay. Maximum loss in

either direction is equal to strike price differential of one vertical spread (5) minus initial

credit.

Break-even Point: Upside: Strike price of straddle + net premium received. Downside:

Strike price of straddle - net premium received.

Time Decay: Positive. If XYZ is near the strike price (60), profits from decay accelerate

most rapidly in last few weeks before expiration.

Volatility: Because an increase in volatility has a larger impact on the two options

making up the straddle than the two OTM options, an increase in volatility is a negative

for the spread. The impact will depend to a large part on both the amount of time left

until expiration and the price of XYZ relative to the strike price. Because an increase in


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volatility can have a negative impact, it is important that the implied volatilities of XYZ's

option be near historic highs before an investor consider this spread.

Assignment Risk: This spread contains two written options. The investor must watch

XYZ for possible assignment if XYZ is either significantly above or below the strike price

as expiration approaches. By monitoring the time premium of the in-the-money option,

the investor can determine the likelihood of assignment. The butterfly spread is a

neutral options trading strategy that is a combination of a bull spread and a bear spread.

It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a

butterfly spread and it can be constructed using calls or puts.

Long butterflies are entered when the investor thinks that the underlying stock will not

rise or fall much by expiration. Using calls, the long butterfly can be constructed by

buying one lower striking in-the-money call, writing two at-the-money calls and buying

another higher striking out-of-the-money call. A resulting net debit is taken to enter the

trade, hence it is also a debit spread.

A long butterfly spread can also be constructed using puts and is known as a long put

butterfly.

A butterfly spread is a long strangle with a short straddle. Strikes for the strangle

bracket the strike for the straddle.

Payoff of a Butterfly Spread


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The most bearish of options trading strategies is the simple put buying strategy utilised

by most novice options traders.

In most cases, stock price seldom make steep downward moves. Moderately bearish

options traders usually set a target price for the expected decline and utilise bear

spreads to reduce risk. While maximum profit is capped for these strategies, they

usually cost less to employ. The bear call spread and the bear put spread are common

examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the

underlying stock price do not go up on options expiration date. These strategies usually

provide a small upside protection as well.

Neutral or Non-Directional Strategies

Neutral strategies in options trading are employed when the options trader does not

know whether the underlying stock price will rise or fall. Also known as non-directional

strategies, they are so named because the potential to profit does not depend on

whether the underlying stock price will go upwards or downwards. Rather, the correct

neutral strategy to employ depends on the expected volatility of the underlying stock

price.

Examples of neutral strategies are: Bear PUT Ladder - Bull CALL Ladder- Guts- Long

Box- Long Call Butterfly -Long Call Condor-Long Call Synthetic Straddle-Long Iron

Butterfly-Long Put Butterfly-Long Put Condor -Long Put Synthetic Straddle-Short Call

Butterfly -Short Call Condor-Short Call Synthetic Straddle -Short Guts-Short Iron

Butterfly-Short Iron Condor-Short Put Synthetic Straddle-short straddle- short strangle-

Straddle-Strangle

Bullish on Volatility


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Neutral trading strategies that are bullish on volatility profit when the underlying stock

price experience big moves upwards or downwards. They include the long straddle,

long strangle, short condor and short butterfly.

Bearish on Volatility

Neutral trading strategies that are bearish on volatility profit when the underlying stock

price experience little or no movement. Such strategies include the short straddle, short

strangle, ratio spreads, long condor and long butterfly

KEY OPTION STRATEGIES

OUTLOOK YOUR EXPECTATIONS & RECOMMENDED STRATEGIES

BULLISH> very bullish >> buy call

> moderately bullish and you are sure the price will not fall >> bull spread

> moderately bullish and you think the price will not fall >> sell put

BEARISH > very bearish >> buy put> moderately bearish and you are sure the price will not rise >> bear spread

NEUTRAL > you hold stock and expect no movement >> sell covered call

VOLATILE

> you expect prices to be very volatile >> buy straddle

> you expect prices to be volatile >> buy strangle> you think the price will not fluctuate much >> buy butterfly> you expect prices to be moderately volatile >> sell butterfly


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Energy Trading {Unit 05}