Energy companies for which refining crude oil is a large part of their business are subject to variations in the crack spread: The difference between the cost per barrel of crude oil and the two major products of the refining, or cracking, process. The products are heating oil and gasoline, both of which have a certain amount of price volatility that is transferred, along with variations in the price of crude oil, to the crack spread.
The energy crack spread is defined in terms of futures on crude oil, heating oil and gasoline. There are 42 gallons of heating oil, and 84 gallons of gasoline, for every three barrels of crude oil. Each heating oil and gasoline futures contract equals 1,000 barrels, or 42,000 gallons.
For example, on July 16, 2012, December 2012 heating oil, gasoline or RBOB (Reformulated gasoline Blendstock for Oxygen Blending) and crude oil futures had closing prices of $2.7932, $2.9711 and $87.10, respectively. To compute the crack spread, the total price of three barrels of crude oil, $261.30, is subtracted from the sale of 42 gallons of heating oil and 84 gallons of gasoline, and the difference is divided by three. This is what is known as the “3-2-1 crack spread”:
($117.31 + $249.57 – $261.30) / 3 = $35.19
Spread over time
Over the past five years, the crack spread has varied from a low near $5 to highs around $35. The current rising trend in the crack spread is shown on “Energy equities and the crack spread” (below). Although the difference between crude oil prices and a refiner’s product prices would seem to be a possible predictor of a petroleum company’s stock price, this chart does not confirm the theory. Note that two significant short-term price trends — up and down — are led by Valero and Tesoro stock prices. In any case, the equities are more volatile than the crack spread, with cumulative percentage changes varying over a 40-percentage-point range compared with the crack spread’s 20-point range.
An improved fit with the prices of Valero and Tesoro stocks is achieved by combining the equities with heating oil minus gasoline RBOB. The data in “Heating oil less gasoline” (below) are cumulative percentage changes, permitting a comparison of several different series having different absolute values. This shows the ability of heating oil to match equity price changes for the two companies, as well as the enhanced effect when gasoline is subtracted from heating oil price changes.
“Cumulative percentage changes” (below) combines the three crack spread variables — crude oil, heating oil and gasoline — and shows that they all are correlated positively with the Valero equity series. Near June 1, 2012, Valero’s stock price is seen leading the other variables as energy futures increase toward mid-July. Although the crude oil price also is increasing, heating oil and gasoline are climbing faster, improving the crack spread and supporting the higher stock price.
The comparative volatility of energy equities is expressed again on “Energy call options” (below). Valero and Tesoro have the two highest call price curves, while the components of crack spreads are in the middle. Chevron, one of the largest integrated energy companies with products in all segments of the petroleum and natural gas industries, has the lowest volatility.
Exploiting with options
The close proximity of the curves on “Energy call options” suggests some potentially profitable spread possibilities. For example, Valero and Tesoro stock prices are similar in volatility, as are the prices of gasoline and heating oil futures.
On “Heating oil/gasoline spread” (below), the difference between the two December 2012 futures prices varies from 32¢ to 41¢ per gallon, or $3,780 for 0.09 of one option point valued at $42,000. This is the maximum spread over the period shown, but there would have been other opportunities including two moves of 6¢, approximately $2,520 each way, starting at April 13 and May 25. This spread often is called “the widow maker.”
The “Cumulative percentage changes” chart shows that all of the associated crack spread variables tend to move together over extended periods, so that watching for shifts in pricing can focus on short-term seasonal — primarily weather-related — influences together with market and geopolitical influences. Currently, heating oil is following its typical seasonal movement, generally falling from January to June, then rising from July through November. This trend has a positive impact on energy-related equities.
Forecasting crack spreads is possible by using the upper and lower breakeven prices computed by the option pricing regression model, LLP (available at futuresmag.com as a free Excel download worksheet). Breakeven prices show the upper and lower futures price at expiration that would permit an initial delta spread (long the number of call options specified by the slope, or delta, of the option price curve while selling short one underlying futures contract) to be free of profit or loss at expiration.
On June 26, 2012, the following breakeven prices existed for December 2012 futures:
| Futures | Strike | Upper | Lower | |
| Heating oil | 2.5976 | 2.70 | 3.040 | 2.307 |
| Gasoline RBOB | 2.2438 | 2.30 | 2.585 | 1.825 |
| Crude oil | 81.04 | 86.00 | 101.914 | 73.197 |
With December futures prices current as of mid-July, the energy crack spread forecast is 18.119. The upper breakeven spread is 13.028, and the lower spread is 10.201. The forecast is biased to the low side by the crude oil upper breakeven price having a greater percentage gain over the current price than either heating oil or gasoline.
Ethanol & corn
The growth of ethanol as an energy source requires adding the spread between ethanol and corn prices to the 3-2-1 crude oil, heating oil and gasoline crack spread.
During June 2012, Valero Energy Corp. idled two ethanol plants, each with more than 110 million gallons per year capacity. This action is due at least in part to the reduction in the margin of income over cost, as shown on “Ethanol/corn spread” (below). After a period of slowly declining positive margins, the price of corn accelerated much faster than the price of ethanol starting in mid-June (47% for corn vs. 32% for ethanol from June 18 to July 18). Although this situation is a temporary problem for Valero, it illustrates the need to expand the usual definition of crack spread to include other energy sources.
The relative importance of ethanol in Valero’s inventory mix was outlined in notes to the company’s financial statements dated March 31, 2011. Refinery feedstocks equaled $2.8 billion, refined products and blendstocks were $988 million, and ethanol feedstocks and products were $250 million.
We noted that energy stock prices do not correspond well with the crude oil crack spread. One reason for this is the increasing role of alternative fuels and their varied impacts on earnings and stock prices. Another important reason is the hedging of costs (crude oil and corn, for example) by petroleum refiners and ethanol producers.
Ultimately, energy crack spreads may be viewed as a measure for the need to hedge, with declining positive, or negative, spreads resulting in a potential increase in the volume and open interest in trading of futures, options and swaps related to energy derivatives.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
