Crack Spread Hedging - Glen/Traf Grad Questions
I was looking at this example question and had a couple of questions. Firstly, why is the crude simultaneously bought and stored gasoline sold in the physical market? Wouldn't it be the case that the crude is bought / processed first and then sold as the refined product the following month (bought in February and then sold in March as gasoline)? Secondly, is the use of crude oil / gasoline futures merely to protect the refinery against adverse prices (flat price risk where crude stabilizes or rises and/or gasoline declines)? Thanks!
In January, Refiner sells the 1:1 Gasoline Crack Spread Futures contract at $17.20:
Sells 1 May RBOB gasoline futures contract at $1.60 per gallon ($67.20 per barrel) Buys 1 April CL futures contract at $50.00 per barrel
Locks in the crack spread at $17.20 per barrelIn the Cash Market in March, Refiner sells the Gasoline Crack Spread at $13.50:
Sells 1000 barrels of physical gasoline at $1.75 per gallon ($73.50 per barrel) Buys 1000 barrels of physical crude oil at $60.00 per barrel
Receives a positive cracking margin of $13.50 per barrelIn March, Refiner buys back (liquidates) the 1:1 Gasoline Crack Spread Futures contract at $13.50 per barrel:
Buys 1 May RBOB gasoline futures contract at $1.75 per gallon ($73.50 per barrel) Sells 1 April CL futures contract at $60.00 per barrel
Futures gain of $3.70 per barrel (which can be applied to the cash market cracking margin)Profit/Loss calculation:
Hedged crack spread = $17.20 per barrel
Un-hedged cash market cracking margin = $13.50
Basically what is happening here is that in January the refiner locked in a margin they liked to secure it for April to May WTI to RBOB conversion. When march comes, they actually execute the physical contracts (purchase of crude and sale of gasoline), but at that time the crack tightened. So while they have tighter margins physically, financially they already secured the 17.2$ and therefore the MTM is in their favor. When the physical contracts are written, they can buy back the financial crack and profit from that, while making 13.2 on the physical spread.
Adding to the above: note that the crack they are selling is April crude to May gasoline. So they are pricing in the 1 month processing time
To clarify, the purpose of "realizing" a crack spread is to lock in a margin, as you say, and, thus, protect against the downside risk of it later tightening (in this case, a January lock-in for the crude oil to gasoline crack spread across April-May)? My second follow-up is concerning what exactly happens on the physical side of the trade. Does the refinery just go to market in March and purchase crude oil and sell gasoline that it already had in stock or did it arrange for the buying of crude and selling of gasoline since January for March delivery? Would love some insight on this. Thanks!
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