Energy Trading {unit 05}

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

149

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.

150

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 output—2 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 trader’s 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.

151

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. 152

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 $2.20 per 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: $176.4 Two barrels of crude ($75 x 2) = $150.00 Therefore, $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 crack spreads 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 153

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




Refiner’s 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 154

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 backwardation—i.e., when the prices for prompt months are higher than the prices for further months—storage 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 155

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 on the 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 156

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 magnitude of price movement in the underlying security, regardless of the direction of 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 bought at 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.

157

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

158

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 price—usually at the money. Long and short straddle payoffs are depicted in Exhibits 1&2

159

Payoff of a Long Straddle Exhibit 1

A long straddle is a bet on high volatility. It makes 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.

160

Long Butterfly A Long Butterfly is a Short Straddle with a conservative twist! By purchasing two out-ofthe-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 161

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

162

A butterfly spread comprises a long strangle with a short straddle. A calendar spread is a long-short position is two calls or two puts. Both options have the same strike, but they have different expirations. Bullish Strategies Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. In most cases, stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. The bull call spread and the bull put spread are common examples of moderately bullish strategies. Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price do not go down on options expiration date. These strategies usually provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy. Bearish Strategies Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy.

163

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 strangleStraddle-Strangle Bullish on Volatility

164

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

> very bullish >> buy call BULLISH > 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

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

165

166