Over the last few years, crude oil prices have dropped from over $100 per barrel to below $40 per barrel. During the same time period, prices of both gasoline and heating oil almost halved. Facing such drastic changes in both input and output prices, oil refineries are presented with challenging risk management decisions.

A typical oil refinery’s profit margin is tied directly to the price difference between crude oil and refined products, commonly called the crack spread. The most popular crack spread, which approximates the real-world output ratio from the refining process, adopts a 3:2:1 ratio, namely, three barrels of crude oil can be cracked into two barrels of gasoline and one barrel of heating oil.

Oil refineries can reduce their risk exposures to volatile market prices by hedging the crack spread in the futures market. In 1994, NYMEX launched the crack spread contract, which bundles the purchase of three crude oil futures contract with the sale of two unleaded gasoline futures contract and one heating oil futures contract (with delivery a month later) and makes them a single trade, thus lowering margin costs. A 3:2:1 crack spread futures position can also be created as a synthetic contract by directly trading futures on crude oil, gasolines and heating oil at a fixed 3:2:1 ratio. Even though the crack spread futures has a very low trading volume, the data show that the trading volume in the synthetic 3:2:1 crack spread is pretty high.

However, given the somewhat erratic behaviour of spot prices in recent years, the question arises whether hedging individual commodities at a ratio other than 3:2:1 might be more effective. Indeed, Kaminski explains that:

“This [3:2:1 ratio] wasn’t a perfect hedge by any definition … The decoupling of the WTI [West Texas Intermediate] prices from the world prices reduced the efficiency of the 3:2:1 hedge and induced many hedgers to switch to Brent futures as the preferred hedging instrument…”.

Yet, compared with hedging crude oil, hedging the crack spread has received much less attention in the literature.

Crack Spread Hedging

Commodity processing activities always involve multiple commodities and thus exposure to price risk on both the input and output side. The literature on hedging has traditionally focused on single-commodity hedging, which does not take into account price co-movements between the input and output commodities

The crack spread hedging problem for oil refineries has attracted interest in recent years, partly due to the highly volatile oil market. Various multivariate modelling methods as well as risk measures have been used to determine optimal hedging strategies and to analyse their performance. It has been shown that accounting for time variation in the relationship between energy price series (crude oil, gasoline and heating oil) yields substantial rewards to hedgers in terms of risk reduction.

Crack Spread History
Crack Spread History

Latest crack spread research

Writing recently in Energy Economics, Liu, Vendenov and Power, reported on the effectiveness of crack spread hedging strategies during a period of high volatility and changing patterns in the prices crude oil and petroleum.

The key finding of their paper was that allowing deviations from the fixed 3:2:1 ratio improves hedging performance regardless of the criterion used. Furthermore, it appears that the key factor affecting hedging effectiveness is the dependence structure between the spot and futures price log returns.

The commonly used way of hedging the crack spread at the fixed 3:2:1 proportion is found to be generally less effective in reducing price risk than a strategy allowing for hedging individual commodities separately. This result is robust across several hedging criteria and measures of hedging performance used. Differences in hedge ratios and hedging performance are most pronounced during 2013 and 2015.

Theory into practice

From a practical standpoint, these results suggest that refineries can generally achieve a better risk-reduction performance by hedging individual commodities than by hedging the crack spread in a fixed 3:2:1 proportion. The advantage of hedging commodities individually becomes particularly important during periods characterised by greater variation of the cross-dependence between the log returns of individual commodities. Finally, using LPM2 as a hedging criterion may not only help hedgers to better track downside risk, but also appears to lead to higher expected profit and a lower expected shortfall.

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