Oil Trading Interview Question - Selling the RBOB Crack
Let’s say you know someone who wants to buy 50,000 barrels of a blendstock that will allow them to complete an in-tank blend. They want you to act as a middle-man and find them this blendstock. These are often hard to value, but you know what they’re bidding and decide to figure out if you can make a deal. You find a blendstock that works being offered on EFP at NYMEX WTI + $5 per barrel DELIVERED into tank in Los Angeles (how nice of them!). However, your contact who is in need of the blendstock is bidding on EFP based on a price of April RBOB minus 10 cents per gallon. Assume that RBOB futures are currently at $3.00/gallon and WTI is at $100/bbl
How can you manage your risk properly and lock in the profit? I think the easiest way to continue looking at “locking in” profits is to look at what your position will look like after the deal without locking in. Then you can work backwards to figure out what you need to do as you enter the deal. Here is what we know so far:
Buy 50mb Blendstock at $105 per barrel ($100 WTI + $5 Diff) Sell 50mb Blendstock at $2.90 per gallon, which equals $121.80 per barrel ($3.00 RBOB - $0.10 Diff * 42 gal/bbl)
Sell 50 WTI at $100 Buy 50 RBOB at $3.00
From looking at your ultimate position, you now know that you would be left short 50 contracts of WTI and long 50 contracts of RBOB. To close your position, you simply need to close those positions! Since you know that you are sitting in a profitable position, you would sell 50 RBOB contracts and buy 50 WTI contracts (called selling the “RBOB crack”). Once you have completed executing those futures contracts, you have finalized your profit. This is the definition of risk-free profit. It just may take a couple of steps to get you to where you want to be, but if it was easy, everyone would do it.
In practice, you may see a number of different publications and products, but if you simply work backwards from your final position, you will always know how to lock-in a profitable trade. Isn't arbitrage great?
Came across this example for interview prep but am struggling to understand one thing; namely, the hedging side of it. As I understand it, the physical side is profiting off of a blending arb that produces the $105 to 121.80 profit differential. How does WTI futures and Buying RBOB contracts hedge the flat price risk / make it a "risk-free" profit?
Ah, diving into the nitty-gritty of oil trading, are we? Let's break it down to make it as clear as a sunny day in the commodities market.
First off, the essence of your question revolves around the concept of hedging and how it transforms a potentially volatile situation into a "risk-free" profit scenario. In the example you're wrestling with, the hedging mechanism is beautifully illustrated through the buying and selling of futures contracts for WTI and RBOB.
Here's the breakdown:
The Physical Trade: You're buying 50,000 barrels of blendstock at $105 per barrel and selling it at an equivalent of $121.80 per barrel after blending. This gives you a gross profit on the physical product.
The Risk: The risk here is the flat price risk, which is the risk that the price of the underlying commodities (WTI crude oil and RBOB gasoline) will move against you in the period between committing to the trade and completing it. If the price of WTI falls or the price of RBOB rises more than expected, your profit margin could be squeezed or even turn into a loss.
The Hedge: To hedge this risk, you enter into futures contracts for both WTI and RBOB. Specifically, you sell RBOB futures and buy WTI futures. This is known as selling the "RBOB crack."
Selling RBOB Futures: By selling RBOB futures, you lock in the price at which you can sell RBOB in the future. If the market price of RBOB falls, the gain on your futures position offsets the loss on the physical trade.
Buying WTI Futures: By buying WTI futures, you lock in the price at which you can buy WTI in the future. If the market price of WTI rises, the gain on your futures position offsets the increased cost of the physical blendstock.
Risk-Free Profit: The combination of these futures contracts means that you have locked in the price differential between WTI and RBOB, independent of where the market prices move. Your profit on the physical trade is secured by the futures, making it "risk-free" from the perspective of price movements.
Execution: It's crucial to execute these futures contracts in the correct quantities to fully hedge your position. In this case, selling 50 contracts of RBOB and buying 50 contracts of WTI aligns with the physical trade of 50,000 barrels, ensuring that the hedge is effective.
In essence, the futures contracts serve as a financial shield against the volatility of oil prices. By locking in prices for both the input (WTI) and the output (RBOB), you're insulated from market swings, allowing you to pocket the arbitrage profit without losing sleep over potential price movements. This is the beauty of hedging in the commodities market – turning a wild ride into a leisurely stroll through the park. Isn't the world of oil trading just fascinating?
Sources: Physical Oil Trading Basics (Part 1 of 2), Physical Oil Trading Basics (Part 1 of 2)
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