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| Crack Spreads |
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In recent years, the use of crack spreads has become more widespread as crude and product prices have fluctuated dramatically in response to extreme weather conditions or political crises. The spreads have displayed related volatility.
The extremely cold weather in December 1989, the Persian Gulf crisis of 1990-91, and the attempted Soviet coup in August 1991 each had an impact on the prices of crude oil or refined products, sometimes generating high margins for refiners and marketers, but at other times severely squeezing their profitability.
Other changes in market conditions and prices can have a more subtle, but still significant impact on prices. Recent environmental rules governing the formulation of gasoline and the sulfur content of distillate fuels that are hedged with NYMEX Division heating oil futures and options have already been felt in the marketplace.
On October 7, 1994, the Exchange launched crack-spread options contracts, the first exchange-traded contracts written on inter-market spreads. The options are listed as two separate contracts, one on the spread between New York Harbor unleaded gasoline and light, sweet crude oil futures, the other on the heating oil/crude oil spread. They are used to help refiners and other gasoline market participants lock in margins.
The crack spread options trade with a one-to-one ratio of crude oil to the product. They differ from conventional options in that a single options position results in two futures positions when the option is exercised.
Crack spread options are an important tool for refiners and downstream marketers who need to protect against the changing relationship between crude and product markets caused by these and other factors including changes in crude supply and product demand, seasonal market dynamics in heating oil and gasoline, changing inventory patterns and replacement costs, and changes in market contango and backwardation.
Crack spreads often reflect real world refining ratios. A popular spread is the 3-2-1 spread which uses the prices of three barrels of crude, two barrels of gasoline, and a barrel of heating oil to determine the spread. Another common spread uses the 5-3-2 ratio and many other ratios are used as well. Hedging crack spreads with futures locks a market participant into a differential which may require him to relinquish a favorable market move in return for price stability.
Crack spread options are also designed to protect the refining margin, while at the same time allowing refiners and other market participants to take advantage of favorable changes in the spread, the only cost being that of the up-front option premium.
Unlike futures crack spreads whose crude-to-product ratios are tailored by traders to best fit their needs, crack spread options are standardized Exchange instruments. The one-to-one ratio of the options meets the needs of many refiners, because it reflects a refiner's exposure related to the manufacture of gasoline and heating oil throughout the year.
A futures crack spread executed on the Exchange is treated as a single transaction for the purpose of determining a market participant's margin requirement. Specifically, the minimum margin requirement takes into account that the risk on one side of the spread is generally reduced by the other leg of spread. Similarly, crack spread options allow the hedge to be accomplished with the payment of one option premium instead of two. Crack spread options also offer the inherent advantages of outright options on futures which allow market participants with commercial exposure to tailor their hedge to their price risk without giving up the ability to participate in favorable market moves.
When the holder of a crack spread call exercises his contract, the writer of the option is obligated to sell him a gasoline or heating oil futures contract and purchase a crude oil futures contract for the agreed upon spread relationship.
Conversely, when a crack spread put is exercised, a writer is obligated to purchase a gasoline or heating oil futures contract from the holder, and to sell him a crude oil futures contract at the agreed upon spread value.
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.
- Crack spread options allow refiners to generate income by writing options.
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