Refining Utilization And Crack Spreads

Refiners regularly trade crack spreads in the futures market to hedge their operating margins against market volatility. Speculators, too, trade the spreads, enticed by the 75 percent margin credit granted by the NYMEX clearinghouse.

Those anticipating an expansion in refiner profits—in other words, fatter cracks—typically sell crude oil futures and simultaneously purchase heating oil and gasoline contracts. "Buying the crack" in this fashion makes money, as crude oil costs lag increases in the prices of refined products.

Conversely, shrinking refiner margins can be profitably exploited by "selling the crack"—buying crude while shorting gasoline and heating oil.

Cracking The Current Market With ETFs

When the economy faltered, crack spreads narrowed, so, it makes sense that they'd widen as we pull out of recession. Earlier this month, the 3-2-1 crack was scraping along at $4.45 a barrel, while its 2-1-1 analogue was $5.13. Just two weeks later, the spreads have built up to $7.40 and $7.94, respectively.

Impressive as these gains are, the spreads are still well below their year-to-date medians—$10.80 for the 3-2-1 crack and $11.65 for the 2-1-1 spread. Keeping that in mind, there's likely to be more upside potential for traders buying the crack, even at these levels.

Nowadays, however, traders can capture spread changes without resorting to the futures market. The introduction of crude oil, gasoline and heating oil exchange-traded funds allows investors to trade the spread margin free—at least the 2-1-1 version, anyway.

Buying equal lots of the ProShares UltraShort DJ-UBS Crude Oil ETF (NYSE Arca: SCO), the United States Gasoline Fund (NYSE Arca: UGA) and the United States Heating Oil Fund (NYSE Arca: UHN) effectively puts an investor short two units of crude oil and long one unit each of gasoline and heating oil. In other words, this three-legged purchase simulates buying the crack.

The ETF version of the spread makes life fairly simple for an investor. It can be transacted in a securities account; no futures account is needed. Even better, the spread can be held with relative impunity, even when refining margins aren't improving.

For example, the returns earned from holding the ETF spread since the top of the year—not the most favorable of margin environments—would have been 3 percent. That's a 3 percent gain, mind you, which doesn't sound all that impressive until you compare it with the results of holding the futures analogue: A fully collateralized futures spread would have lost 14.6 percent. Factor in the leverage afforded by margin, and you're talking about a much larger potential loss.

Part of this risk disparity is due to volatility, which is much smaller in the ETF version of the spread—less than a fifth of the volatility of the futures-based spread, in fact.

There's a lot less maintenance required of the ETF spread as well. Contracts don't have to be rolled over, there's no contango or backwardation to deal with (not directly, that is) and investors don't have to worry about changes in margin requirements.

2-1-1 Crack Spread: Futures Vs. ETFs

You can see that the ETF version tracks the 2-1-1 crack fairly well, although not exactly. The differential is due to a couple of factors. First of all, the ETF spread reflects the last sale data typically available to retail investors, while the futures spread is based upon settlement values, not last-sale data. Using end-of-day bids or fund NAVs would narrow the apparent difference significantly.

Nor is contango reflected in the ETF spread. By design, the product ETFs are continuously invested in front-month futures, rather than the back-month contracts dictated by a refining simulation. Contango's generally shrinking now, but earlier this year, it was a significant source of dissonance.

The economy may still have a few tricks up its sleeve this Halloween, but those traders eager to wager on recovery now have a trick of their own that just might turn the crack spread into a real treat.

 Prev12Next