In the relatively small world of energy futures and options, there are certain relationships that may be counted on to enhance trading profits. For example, a commodity that is the end-product of a succession of other commodities certainly will have its price influenced by those that precede it in the production process. This may be seen in the price of beef and pork as well as in the cost of gasoline at the pump. The chain-of-command begins in the futures market, in which forecasts of prices shaded by implied volatilities give an advanced view of leaders and followers.
“Crack spread relationships” (below) illustrates several relationships among June 2013 futures contracts for crude oil (WTI), gasoline (reformulated blendstock for oxygenate blending), heating oil and Brent crude oil. After remaining in the background in the last months of 2012, gasoline showed its pricing strength by a rapid gain through mid-February while dragging the other energy futures along with it. From this point through March 28, the energy followers reflect the ups and downs of gasoline’s price variations.
Although a close-fitting pair — heating oil and Brent crude oil — is part of those that are heavily influenced by gasoline price movements, it has a separate life as a crack-spread team. “Crack spread relationships” illustrates this attachment by plotting cumulative percentage price changes for June 2013 futures contracts. The interplay of price variations suggests that the two futures would be a good trading pair.
One barrier to trading heating oil vs. Brent crude oil futures as a pair is the large difference in price. Heating oil futures are priced by the gallon. On March 28, the June contract was $3.0330 per gal. The price of Brent crude oil covers a 42-gallon barrel. On March 28, Brent June futures were trading at $109.79. Although the futures prices are far apart, we know from the cumulative change chart that their price movements are related closely.
“Close friends” (below) tracks the spread from Oct. 1, 2012, through March 28, 2013. The spread is computed by multiplying the heating oil futures price by 42 gallons per barrel and subtracting the price of a barrel of Brent crude oil.
To trade the heating oil-Brent crude oil spread in the form just described would involve multiple heating oil contracts to equalize gallons and barrels. Fortunately, this spread has been recognized by CME Group and the IntercontinentalExchange (ICE), although the exchanges specify the spread differently. The ICE heating oil-Brent spread permits trading the spread between the ICE heating oil futures and ICE Brent futures. The spread trade consists of a long position in ICE heating oil futures and a short one in ICE Brent futures, with all positions financially settled.
The CME Group’s heating oil-Brent spread futures primarily specifies a floating price for each contract month equal to the arithmetic average of the New York Harbor No. 2 heating oil futures first nearby contract month settlement price minus the arithmetic average of the ICE Brent crude oil futures first nearby month settlement price.
An approximation of the spread futures offered by CME Group and ICE is the spread between two futures on a nearby contract month shown on “Close friends.” The computed spread is a closer fit with the CME Group futures because it consists of a single spread dollar price.
CME Group and ICE both specify a 1,000-barrel trading unit priced in dollars and cents per barrel. Observing the difference between the computed spread and the exchange’s official spread over time should give a trader a better idea of potential price changes in these more convenient spreads. On March 28, the computed crack spread was $17.596 vs. the CME Group spread of $18.048. The difference will vary continuously and can help the trader decide the direction of the traded spread.
A third choice for the heating oil-Brent spread is an exchange-traded fund (ETF). “Third option using ETFs” (below) shows the difference in prices from Jan. 2 though March 28, 2013. On March 28, the closing prices for the ETFs were $33.07 for the U.S. Diesel-Heating Oil Fund LP (UHN), and $83.17 for the U.S. Brent Fund (BNO). Historical and daily price data are available free for both ETFs from Yahoo! Finance.
“Gasoline most volatile” (below) confirms that gasoline has the greatest implied volatility of the four markets (Brent crude oil, gasoline, WTI crude oil and heating oil). The least volatility is exhibited by Brent crude, while heating oil sits in the middle. Implied volatility indicated by the relative heights of the call price curves shows how much variation the options market expects in the underlying over the time to expiration. On March 28, the option price curve heights as a percentage of the strike price where the underlying equals the strike price were 3.57%, 2.91%, 2.895% and 2.57%, respectively, for gasoline, WTI, heating oil and Brent.
“Ethanol, gasoline and corn effect” (below) indicates that gasoline fails the price-leadership test as it pertains to ethanol. Instead, ethanol is much more attuned to its agricultural roots — specifically the price of corn. This is expected because corn is a major cost in refining ethanol. The chart shows cumulative percentage price changes from Oct. 2, 2012, through March 28, 2013. Although all three prices are rising from March 8 through March 27, there are several periods in which ethanol follows corn instead of the fuel-related gasoline futures.
A test of the pricing relationship occurred on March 28, 2013, when May corn futures had a loss of 40 points or $2,000 (the one-day limit). A bearish report by the U.S. Department of Agriculture caused corn futures prices to start crumbling at mid-morning. This price change soon was followed by similar losses for other grain futures, as well as June ethanol futures, which lost 13.4 cents at $29 per 1/10 cent, or $3,886 per contract with no limit on the daily price change. Gasoline futures are shown increasing in price on the same day.
The relationship between ethanol and corn is recognized by the corn crush spread, which may be used by companies producing ethanol to hedge the cost of corn with the income from sale of the distillation process — ethanol and distillers’ dried grains (DDGs) that are sold for animal feed. The corn crush margin, also suitable for speculation, is shown by the CME Group publication “Trading the Corn for Ethanol Crush,” and assumes that one bushel of corn produces 2.8 gallons of ethanol and 17 pounds of DDGs. The crush margin formula is:
(DDG price x 0.0085) + (ethanol price x 2.8) – corn price
Prices in the crush margin formula include DDGs in dollars per short ton multiplied by 0.0085, ethanol in dollars per gallon multiplied by 2.8 and the price of corn in dollars per bushel. As shown by “Ethanol, gasoline and corn,” ethanol varies in price with corn, but there are tradable variations that may be explored and analyzed. Along with futures prices for corn and ethanol, CME Group has announced new futures on DDGs. With this addition, the complex of futures needed for the corn crush should be complete.
In the final analysis, there are two leaders in the energy sector and one of them is not an energy product: Corn. Environmental and political concerns have pushed ethanol to a prominent position, but the underlying supply and price of corn determines its price movements to a large extent, at the same time that ethanol production has a reverse impact on corn.
As always, it is the interplay of prices between two or more commodities that makes profitable spread and crush trades possible.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.