chapter 51 chapter 5 agricultural, energy and metallurgical futures contracts this chapter explores...

Chapter 5 1

CHAPTER 5 Agricultural, Energy and Metallurgical

Futures Contracts

This chapter explores futures contracts on physical commodities, those written on agricultural, energy and metallurgical commodities. This chapter is organized into the following sections:

1. Commodity characteristics that interfere with the Cost- of-Carry Model.

A. Commodity Supply and Storability

B. Commodity Seasonal Production

C. Commodity Seasonal Consumption

D. Commodity Poor Storability

2. Spread

A. Intra-commodity Spreads

B. Inter-commodities Spreads

3. Hedging

Chapter 5 2

Commodity Characteristics

Recall: the Cost-of-Carry Model implies a range of permissible prices. These prices are defined by the cash-and-carry and reverse cash-and-carry arbitrage strategies.

Applying the cash-and-carry arbitrage strategy assumes that the physical good or commodity can be stored from one day to the next.

Applying the reserve cash-and-carry arbitrage depends upon short selling.

Some goods have a convenience yield, which stems from the usefulness of having them in inventory.

Chapter 5 3


Recall: the relationships between cash and futures prices depend upon:

– Storage characteristics of the commodity

– Supplies of the commodity

– Production and consumption cycle for the commodity

– Ease of short selling the commodity

– Transaction costs

In the following section, we begin by discussing how the supply and storability move the market to or away from full carry. Then, we provide examples of commodities that are at full carry and commodities that are not at full carry.

Chapter 5 4

Commodity CharacteristicsSupply and Storability

Insert Figure 5.1 here

Chapter 5 5

Commodity Characteristics Supply and Storability

Table 5.1 presents the various features of the commodities and the expected price behavior.

Table 5.1

Storage and Stock Characteristics and Price Behavior

Storability

Relative Stocks

Example Commodities

High

High

Precious metalsCexpect general conformance to full carry.

Good Production cycle causes fluctuations in stocks

Grains and oilseedsCexpect de-partures from full carry.

Good Consumption cycle causes fluctuations in stocks

Energy productsCexpect depar-tures from full carry.

Poor Low, largely due to poor storability

LivestockCexpect frequent depar-tures from full carry.

Chapter 5 6


SUMMARY

If a good has excellent storage characteristics and a large supply relative to consumption, we expect markets for the good to approximate full carry (e.g., gold).

Commodities with good storability may at some point, depart from full carry, due to fluctuation in production (grains during harvesting time) or fluctuations in consumption (gasoline during summer time).

Commodities with poor storability can depart substantially from full carry (e.g., livestock).

Chapter 5 7

Full Carry Markets Precious Metals

Figure 5.2 shows gold prices for the JUN and DEC futures contracts.

Highly storable commodities with a large supply relative to annual consumption should behave according to the Cost-of-Carry Model.

For precious metals, both the cash-and-carry and reverse cash-and-carry arbitrage strategies are potentially effective because short selling is fairly accessible for precious metals like gold.

Recall: the carrying costs consist of storage, insurance, transportation, and financing charges.


Chapter 5 8

Full Carry Markets Precious Metals

If gold is a full carry market, the following relationship should hold:

)1(,0,0 CFF nd

where d > n

Applying this equation to our present example implies:

DEC gold futures = JUN gold futures (1 + C)

Dividing both sides of the above equation by the right-hand side and subtracting 1, we have:

0 = 1 - ) C + (1 future gold JUN

futures gold DEC

Any time this equation equals something other than zero, an arbitrage opportunity is possible.

Chapter 5 9

A Full Carry Example: Gold

Assume that the prices in Table 5.2 are present in the market and assume that the financing cost is the T-bill rate for the June-December period. All other transaction costs are ignored. We would like to know if the market is at full carry.

Table 5.2

Data for October 13 JUN futures price $426.00 DEC futures price 442.60 TBbill rate (JuneBDecember) 7.7719% HalfByear factor, (1 + C), for JuneBDecember 1.038132

Chapter 5 10


000804. = 1 - )038132.1(00.426

60.442

While this value is close to zero indicating that the market is near full carry, the trader with a total carrying cost equal to the T-bill rate could make a profit from a cash-and-carry strategy.

$442.60 - $426.00 (1.038132) = $.36/ ounce

0 = 1 - ) C + (1 future gold JUN

futures gold DEC

cFF nd 1,0,0

cFF nd 1Profit ,0,0

Chapter 5 11


If the T-bill rate is 7.7719. What is the repo rate?

tt

CS

F,0

0

,01

.0389670 =1 $426.00

$442.60

The futures contract is for ½ year, so to compare this rate to the T-bill rate, we must annualize it as follows:

The difference between the T-bill rate and the repo rate is:

7.9453-7.7719 = 0.1734

Thus, if a trader’s financing cost is below 7.9453%, She/he could engage in a cash-and-carry strategy.

This analysis demonstrates that gold market was very close to full carry on that day.

1038967.01Rate Annual 2

%9453.7Rate Annual

Chapter 5 12

Departure from Full Carry: Gold

Figure 5.2 shows how gold and other precious metals behave in similar fashion.

INSERT FIGURE 5.3 HERE

Chapter 5 13

Departure From Full Carry:Silver

If prices decline, the results of the full carry market equation may be above zero. This is said to be above full carry.

If the market is above full carry, cash-and-carry arbitrage strategies become attractive.

Assuming short selling is possible and that no convenience value exists:

• Borrow money.

• Sell a futures contract.

• Buy the commodity.

• Deliver the commodity against the futures contract.

• Recover the money and payoff loan.

Chapter 5 14

Departure from Full Carry:Silver

If prices rise, the results of the full carry market equation may fall below zero. This is said to be below full carry.

If the market is below full carry, reverse cash-and-carry arbitrage strategies become attractive.

Assuming short selling is possible and that no convenience value exists:

• Sell short the commodity.

• Lend money received from short sale.

• Buy a futures contract.

• Accept delivery of futures contract.

• Use commodity received to cover short sale.

Chapter 5 15

Product Profile: The NYMEX Silver Futures

Contract Size: 5,000 troy ounces. Deliverable Grades: Refined silver, assaying not less than .999 fineness, in cast bars weighing 1,000 or 1,100 troy ounces each and bearing a serial number and identifying stamp of a refiner approved and listed by the Exchange. Tick Size: $.005 or $25 per contract Price Quote: U.S. cents per troy ounce Contract Months: Trading is conducted for delivery during the current calendar month, the next two calendar months, any January, March, May, and September thereafter falling within a 23-month period, and any July and December falling within a 60-month period beginning with the current month Expiration and final Settlement: Trading terminates at the close of business on the third to last business day of the maturing delivery month. Trading Hours: Open outcry trading is conducted from 8:25 AM until 1:25 PM. After-hours futures trading is conducted via the NYMEX ACCESS internet-based trading platform beginning at 2:00 PM on Mondays through Thursdays and concluding at 8:00 AM the following day. On Sundays, the session begins at 7:00 PM. Daily Price Limit: Initial price limit, based upon the preceding day's settlement price, is $1.50. Two minutes after either of the two most active months trades at the limit, trades in all months of futures and options will cease for a 15-minute period. Trading will also cease if either of the two active months is bid at the upper limit or offered at the lower limit for two minutes without trading. Trading will not cease if the limit is reached during the final 20 minutes of a day's trading. If the limit is reached during the final half hour of trading, trading will resume no later than 10 minutes before the normal closing time. When trading resumes after a cessation of trading, the price limits will be expanded by increments of 100%

Chapter 5 16

Departure from Full Carry:The Hunt’s Silver Manipulation Case

In January 1980, the Hunt Manipulation was at its peak and silver hit its all-time record price of $50/ounce.

Traders with no convenience value, delivered silver to benefit from the quasi-arbitrage opportunities.

On Thursday, March 27,1980, the silver manipulation ended, the market crashed, and the silver market quickly returned to almost full carry again.

Figure 5.4 shows the silver market from October 1, 1979 through June 30, 1980.

Chapter 5 17

Departure from Full Carry:Silver

Insert figure 5.4 here

Chapter 5 18

Commodities with Seasonal Production

In this section, we examine commodities that are produced seasonally. To facilitate the discussion assume:

– Consumption of the commodity is steady.

– Long-term inventory is constant.

– Production will equal consumption.

– Commodity stores well (e.g., wheat, corn, oats, barley, soy products).

– Prices exhibit seasonal trends due to harvesting patterns.

Wheat is used to illustrate the seasonal characteristics of commodities.

Chapter 5 19

Inventories and Price Patterns

Insert Figure 5.5a Here

Insert Figure 5.5b here Insert Figure 5.5c here

Chapter 5 20

Inventories and Price Patterns: Basis

A fluctuating basis is often interpreted as a sign of high risk and unstable prices.

However in this example, due to our assumptions, there is no risk.

This shows that the basis may fluctuate radically even under conditions of certainty.

It is important to separate fluctuations in the basis into the expected and unexpected components.

Insert Figure 5.6

Chapter 5 21

CBOT’s Wheat Futures Profile

Product Profile: The CBOT=s Wheat Futures

Contract Size: 5,000 bushels. Deliverable Grades: No. 1 & No. 2 Soft Red, No. 1 & No. 2 Hard Red Winter, No. 1 & No. 2 Dark Northern Spring, No. 1 Northern Spring at 3 cent/bushel premium and No. 2 Northern Spring at par. Substitutions at differentials established by the exchange. Tick Size: 1/4 cent/bu ($12.50/contract) Price Quote: Cents and quarter-cents/bushels Contract Months: July, September, December, March and May Expiration and final Settlement: The last trading day is the business day prior to the 15th calendar day of the contract month. The last delivery day is the seventh business day following the last trading day of the delivery month. Trading Hours: Open Auction: 9:30 a.m. - 1:15 p.m. Central Time, Mon-Fri.Electronic: 7:32 p.m. - 6:00 a.m. Central Time, Sun.-Fri. Trading in expiring contracts closes at noon on the last trading day. Daily Price Limit: 30 cents/bu ($1,500/contract) above or below the previous day's settlement price. No limit in the spot month (limits are lifted two business days before the spot month begins).

Chapter 5 22

Wheat and Wheat Futures

WHEAT ASSUMPTIONS REALITY OF WHEAT Good stored well. It store well, but not forever. Practically,

wheat can be stored for about 5 years or longer.

Prices exhibit seasonal trends due to harvesting patterns.

There are various harvest times which brings wheat almost continually to the market (winter wheat, spring wheat, and wheat harvest overseas (e.g. Argentina)

Although, wheat does not fit our model perfectly. The seasonal factor and the availability of wheat in the US is very strong. Figures 5.7 shows that wheat prices tend to be high during winter and low during summer.

Chapter 5 23

Seasonal Character of Cash Wheat Prices


Chapter 5 24


Table 5.3 shows the average stock of wheat in the US by month from 1969 to 1982. Notice the low inventory for June, and the high level for August and September.

Table 5.3

Average U.S. Wheat Stocks, 1969B1982 Crop Yields Month

Stock (millions of bushels)

Percentage Change (from preceding month)

June

187.78

B9.40%

July

246.37

31.20 August

338.65

37.46

September

380.19

12.27 October

398.40

4.79

November

379.40

B4.77 December

346.41

B8.70

January

314.28

B9.28 February

284.21

B9.57

March

257.42

B9.43 April

236.14

B8.27

May

205.44

B13.01

Chapter 5 25


Based on Table 5.3, high supply should cause a drop in price (other factors held constant).

Table 5.4 shows the seasonal character of cash wheat prices.

Results confirm the view that cash prices should be high when inventories are low and low when inventories are high.

Table 5.4

Months in Which High and Low Cash Wheat Prices for the Year Occurred, 1892B1992

Data are for calendar years for #2 Winter Wheat. Month

Number of Highs

Number of Lows

June

3

10

July

3

23 August

1

22

September

7

4 October

4

6

November

9

8 December

20

2

January

18

9 February

10

5

March

8

3 April

9

6

May

10

3 Source: Chicago Board of Trade, Statistical Annual, various years and computerized data bank.

Chapter 5 26


Table 5.5

Months in Which High and Low Wheat Futures Prices for the Year Occurred, 1963B1995

Data are for the CBOT May contract. Month

Number of Highs

Number of Lows

June

6

6

July

1

8 August

2

2

September

1

1 October

3

1

November

1

0 December

1

0

January

2

0 February

3

2

March

2

3 April

4

2

May

7

8 Source: Chicago Board of Trade, Statistical Annual, various years and computerized data bank.

The large number of highs and lows in these months reflects the large forecasting errors in futures prices when the expiration is distant.

There is no tendency for high prices to occur in one month and low prices to cluster in some other time period. Thus, cash prices can be seasonal, while futures prices for the same commodity are not.

Chapter 5 27


Table 5.6 presents a portion of Telser’s classic study of wheat and cotton futures. Telser concluded “futures data offer no evidence to contradict the simple hypothesis that the futures price is an unbiased estimate of the expected spot price.”

Table 5.6

Telser's Wheat Futures Results, 1927B1941 and 1946B1954

Number of Months Futures Rose

Number of Months Futures Fell

Years of Falling Cash Prices

19

42

Years of Stable Cash Prices

45

56 Years of Rising Cash Prices

52

32

Total

116 (47.15%)

130 (52.85%)

Chapter 5 28

Wheat and the Cost-of-Carry Model

Given the characteristics of wheat, we expect wheat price relationships to differ substantially from the full carry behavior of gold.

First, wheat production is seasonal. Even if the harvest were known well in advance, wheat would still be abundant after harvest and scarce later.

Second, the harvest is not known in advance, so shortages or surpluses of wheat can develop.

In general, we would not expect wheat to behave as a full carry market in all circumstances.

Chapter 5 29

Wheat Versus Gold: The Cost-of-Carry Model

Insert Figure 5.2

JUL and DEC Gold Futures Prices

Insert Figure 5.8 Here

JUL and DEC Wheat Futures Prices

Chapter 5 30

Wheat Versus. Gold: The Cost-of-Carry Model


Deviations from Full Carry for Wheat

Chapter 5 31


WHEAT GOLD Deviations from full carry are much larger (4 times larger for wheat).

Deviation from full carry are minimal.

Stronger trend to deviate from full carry (first below full carry, and later above full carry).

Almost always at full carry.

Distant futures exceeded the nearby futures plus financing cost.

Distant futures never exceeded the nearby futures plus financing cost.

Storage, insurance and transportation are more significant carrying costs).

Financing cost is a significant carrying cost.

Chapter 5 32


Summary:

Wheat cash prices are seasonal, due to fluctuating supply and surprises about the harvest.

The spread between two futures maturities can vary in a systematic way, due to seasonal factors.

Storage, insurance, and transportation costs, as well as the financing cost should be evaluated to determined if a market is at full carry.

Chapter 5 33

Commodities with Seasonal Consumption

In this section, we examine commodities that show seasonal consumption. Particular attention will be given to crude oil.

Seasonal consumption patterns can produce fluctuating stocks of some commodities. This can create shortages and give a convenience value to these commodities.

Oil and related products provide an example of a good with fairly steady production, but highly seasonal demand (e.g., gasoline during summer, heating oil during winter).

Crude oil futures sometimes are at full carry, while at other times, crude oil can have a substantial convenience yield or the market can even be in backwardation.

Table 5.7 shows crude oil prices with virtually every possible price pattern.

Chapter 5 34

Crude Oil Futures Prices

Table 5.7

Crude Oil Futures Prices for March 21 of Various Years Contract Expiration Year

Expiration Month

1984

1985

1986

1987

1988

1989

1990

JUN

30.32

27.76

14.17

18.08

16.19

19.49

19.28

SEP 30.20

27.05

14.60

17.62

16.05

18.45

20.44

DEC 30.28

27.15

15.01

17.57

15.99

17.75

20.44

Chapter 5 35

Commodities with Poor Storability

In this section, we examine commodities that show poor storability. Particular attention will be given to livestock.

Livestock is an example of a commodity with poor storability.

Example:

Live cattle must have an average weight between 1,050 and 1,200 pounds at delivery. If cattle are held too long, they cannot be delivered in fulfillment of the contract.

Difficult storage conditions loosen the no-arbitrage connection between futures contracts with different expirations.

Chapter 5 36

Feeder Cattle and Live Cattle

The CME trades contracts on feeder cattle and live cattle.

The decision to slaughter feeder cattle, or to carry forward for delivery as live cattle, depends on the spread between to feeder cattle and live cattle futures contracts and the cost of feeding.

I PHASE: CALFConception to weaning

II PHASE: FEEDERCATTLE

Feeding ≈1 yrWeight ≈ 600-800 Lbs

Grow More

YesNo

III PHASE: LIVE CATTLE

Weight ≈ 1050-1200 Lbs

TRADEFeeder Cattle

Chapter 5 37

Live Cattle Futures Prices

Figures 5.10 and 5.11 show that there is little chance live cattle adhere to the cash-and carry structure.


Chapter 5 38

Commodities with Poor StorabilityLive Stock


We conclude that the Cost-of-Carry Model does not apply very well to cattle. Prices fluctuate from above to below full carry.

Chapter 5 39

Spreads

In this section, we examine spreads:

1. Intra-commodity spreads.

Every intra-commodity spread must have at least two contracts (one short/one long).

A. Bull Spread

A bull spread is an intra-commodity spread designed to profit if the price of the underlying commodity rises.

B. Bear Spread

A bear spread is an intra-commodity spread designed to profit if the price of the underlying commodity falls.

2. Inter-commodity spreads.

Every inter-commodity spread must have at least two contracts in two different, but related commodities

A. Soybeans complex

B. Energy complex

C. Livestock

Chapter 5 40

Intra-Commodity Spreads

Recall: the Cost-of-Carry Model for a full carry market with perfect markets.

cFF nd 1,0,0

d > n

Recall further: changes in spreads and changes in prices for full and non-full carry markets behaves as follows:

In full carry markets, if the commodity price rises, the distant futures price rises more than the nearby futures price.

In non-full carry markets, if the commodity price rises, the nearby futures price rises more than the distant futures price.

Table 5.9 lists commodities that follow each type of relationship.

Chapter 5 41

Bull and Bear Intra-commodity Spreads

Table 5.9

Bull and Bear IntraBCommodity Spreads Bull Spread

Bear Spread

Commodities

Short nearby Long distant

Long nearby Short distant

Full Carry Markets Gold, silver, platinum, palladium, financials

Long nearby Short distant

Short nearby Long distant

NonBFull Carry Markets Cocoa, copper, wheat, corn, oats, orange juice, plywood, pork bellies, soybeans, soymeal, soyoil, sugar

Chapter 5 42

Inter-Commodity Spread Relationships

In this section, the spread relationships between the following related commodities will be explored:

1. Soy complex

2. The energy market (oil)

3. The livestock market (feeder cattle and live cattle)

Chapter 5 43

Soybeans Futures Market

Product Profile: The CBOT=s Soybean Futures Contract Size: 5,000 bushels. Deliverable Grades: No. 2 Yellow at par, No. 1 yellow at 6 cents per bushel over contract price and No. 3 yellow at 6 cents per bushel under contract price. Tick Size: 1/4 cent/bu ($12.50/contract) Price Quote: Cents and quarter-cents/bushels Contract Months: September, November, January, March, May, July, and August. Expiration and final Settlement: The last trading day is the business day prior to the 15th calendar day of the contract month. The last delivery day is the second business day following the last trading day of the delivery month. Trading Hours: Open Auction: 9:30 a.m. - 1:15 p.m. Central Time, Mon-Fri.Electronic: 7:31 p.m. - 6:00 a.m. Central Time, Sunday.-Friday. Trading in expiring contracts closes at noon on the last trading day. Daily Price Limit: 50 cents/bu ($2,500/contract) above or below the previous day's settlement price. No limit in the spot month (limits are lifted two business days before the spot month begins).

Table 5.10 Soy Contract Quantities

Contract

Quantity per Contract

Method of Price Quotation

Soybeans

5,000 bushels

$ per bushel

Soymeal

100 tons

$ per ton Soyoil

60,000 pounds

cents per lb.

Chapter 5 44

Soybeans and The Crush

Soybeans must be crushed to yield edible soymeal and soyoil. A 60-pound bushel of soybeans produces approximately:

48 lbs. of soymeal 11 lbs. of soyoil 1 lbs. of waste

Crush Margin

The crush margin is the difference in value between a bushel of soybeans and the resulting meal and oil.

One soybeans contract ( 5000 bushels) produces approximately:

120 tons of soymeal or 1.2 soymeal contracts55,000 pounds of oil or 92% of a soyoil contract

10 contracts 5,000 bushels ≈ 2,400,000 lbs. of meal + 550,000 lbs. of oil

≈ 12 contracts of meal + 9 contracts of oil

Chapter 5 45

Soybeans and Crush Spreads

In normal conditions, the value of the meal plus the oil must exceed the value of the soybeans. If this were not the case, there would be no incentive to process the soybeans. Thus, we expect the crush margin to be positive.

The following crush and reverse crush information along with Table 5.11 will be used to illustrate soybean crush spreads.

Crush and Reverse Crush Soybean Spreads Crush spread

Long soybeans of one expiration; short soymeal and soyoil for the next expiration.

Reverse crush spread

Short soybeans of one expiration; long soymeal and soyoil for the next expiration.

Chapter 5 46


Assume that today, August 4, a speculator believes that the crush margin is too small. That is, the speculator believes that by buying beans and selling the combined meal and oil positions, he/she will make a profit.

Table 5.11

Soy Futures Prices

August 4

November 14

December 19

JUL Beans ($ per bushel)

8.6600

7.8525

8.1700

SEP Meal ($ per ton)

232.5000

232.0000

232.0000

SEP Oil ($ per lb.) 0.2665

0.2442

0.2495

Table 5.12 details the transactions the speculator enters to take advantage of his/her beliefs.

Chapter 5 47


Table 5.12

A Soybean Crush Speculation Date

Futures Market

August 4

Buy 10 JUL bean contracts at $8.66 per bushel Sell 12 SEP meal contracts at $232.50 per ton Sell 9 SEP oil contracts at $.2665 per lb.

November 14 Sell 10 JUL bean contracts at $7.8525 per bushel Buy 12 SEP meal contracts at $232 per ton Buy 9 SEP oil contracts at $.2442 per lb.

Profit/Loss: Beans: 10 5,000 (B$8.66 + $7.8525) = B$40,375 Meal: 12 100 ($232.50 B $232) = $600 Oil: 9 60,000 ($.2665 B .2442) = $12,042

Total Loss: B$27,733

Bean prices actually fell resulting in a net loss of $27,733.

Chapter 5 48


Table 5.13

A Soybean Reverse Crush Speculation Date

Futures Market

November 14

Sell 10 JUL bean contracts at $7.8525 per bushel Buy 12 SEP meal contracts at $232 per ton Buy 9 SEP oil contracts at $.2442 per lb.

December 12 Buy 10 JUL bean contracts at $8.17 per bushel Sell 12 SEP meal contracts at $232 per ton Sell 9 SEP oil contracts at $.2495 per lb.

Profit/Loss: Beans: 10 5,000 ($7.8525 B 8.17) = B$15,875 Meal: 12 100 ($232 B $232) = 0 Oil: 9 60,000 (B$.2442 + .2495) = $2,862

Total Loss: B$13,013

Now the speculator believes that the prices will continue to fall, so the speculator enter the market again with the transactions as shown in Table 5.13.

Bean prices rise causing the speculator another net loss of $13,013.

Chapter 5 49

Oil and the Crack

Product Profile: The NYMEX=s Light, Sweet Crude Oil Futures

Contract Size: 1,000 U.S. barrels (42,000 gallons). Deliverable Grades: Specific domestic crudes with 0.42% sulfur by weight or less, not less than 37 API gravity nor more than 42 API gravity. The following domestic crude streams are deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet, South Texas Sweet.Specific foreign crudes of not less than 34 API nor more than 42 API. The following foreign streams are deliverable: U.K. Brent and Forties, and Norwegian Oseberg Blend, for which the seller shall receive a 304-per-barrel discount below the final settlement price; Nigerian Bonny Light and Colombian Cusiana are delivered at 154 premiums; and Nigerian Qua Iboe is delivered at a 54 premium. Tick Size: One cent per barrel ($10 per contract) Price Quote: U.S. dollars and cents per barrel. Contract Months: Thirty consecutive months plus long-dated futures initially listed 36, 48, 60, 72, and 84 months prior to delivery. Expiration and final Settlement: Last trading day is the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day of the month is a non-business day, trading shall cease on the third business day prior to the business day preceding the 25th calendar day. Delivery at Cushing, Oklahoma at any pipeline or storage facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or inter-facility transfer Deliveries are permitted over the course of the month and must be initiated on or after the first calendar day and completed by the last calendar day of the delivery month. Trading Hours: Open outcry trading is conducted from 10:00 AM until 2:30 PM. After-hours futures trading is conducted via the NYMEX ACCESS7 internet-based trading platform beginning at 3:15 PM on Mondays through Thursdays and concluding at 9:30 AM the following day. On Sundays, the session begins at 7:00 PM. Daily Price Limit: $10.00 per barrel ($10,000 per contract) for all months. If any contract is traded, bid, or offered at the limit for five minutes, trading is halted for five minutes. When trading resumes, the limit is expanded by $10.00 per barrel in either direction. If another halt were triggered, the market would continue to be expanded by $10.00 per barrel in either direction after each successive five-minute trading halt. There will be no maximum price fluctuation limits during any one trading session.

Chapter 5 50

Oil and the Crack

Crude oil must be refined into other products (e.g., gasoline, heating oil, or propane).

Cracking

Cracking is the process of refining crude oil. The same crude oil can produce a variety of products depending on the techniques used to crack it.

A barrel of oil can only produce a certain amount of total product. The mix is variable, but the total output is a zero-sum game.

Cracking patterns are largely governed by the season of the year (more gasoline will be produce during summer, and more heating oil during winter).

Crack Spread

The price relationship between crude oil and its refined products.

Chapter 5 51

Oil and the Crack

There are several kinds of crack spreads, including:

1. Crude oil/heating oil crack spread

1 barrel crude oil ≈ 1 barrel gasoline

2. Crude oil/gasoline crack spread

1 barrel crude oil ≈ 1 barrel heating oil

3. Other Combination based on multiple units of crude oil

2 barrels crude oil ≈ 1 barrel gasoline1 barrel heating oil

Buy a Crack Spread

The trader buys the refined product and sells the crude.

Sell a Crack Spread (Reverse Crack Spread)

The trader sells the refined product and buys the corresponding crude.

The most popular crack spreads are the 1:1 spreads between crude and heating oil or crude and gasoline.

Chapter 5 52

Oil and Crack Spreads

Table 5.14 shows the contract specifications for crude oil, heating oil and gasoline.

Table 5.14

Energy Complex Futures Contract Specifications Commodity

Contract Quantity

Price Quotations

Grade

Crude Oil

1,000 barrels

$ per barrel

West Texas Intermedi-ate

Heating Oil

42,000 gallons

$ per gallon No. 2

Gasoline

42,000 gallons

$ per gallon Unleaded

1 barrel = 42 gallons

Figures 5.12 shows the prices of July crude oil and heating oil futures in dollars per gallon and 5.13 illustrates the spread.

Chapter 5 53



JUL Crude and Heating Oil Futures

Insert Figure 5.13 Here

Spread between JUL Heating and Crude Oil Futures

Chapter 5 54


Assume that today, March 16; a trade has gathered the information from Table 5.15. The trader believes that the $.0616 crude oil/ heating oil crack is not sustainable ($.4569-$.5185= $.0616). The trader thinks that the justifiable refining spread is only $.04 per gallon. Therefore, the trader expects the spread to narrow and thus decides to enter into a reverse crack spread (sell heating oil and buy crude oil).

Table 5.15

Energy Complex Futures Prices Date

Crude Oil

($ per gal.)

Heating Oil ($ per gal.)

Crack

Heating Oil B Crude Oil March 16

.4569

.5185

.0616

June 8

.5017

.5628

.0611 June 3

.4700

.5419

.0719

Table 5.16 shows the transactions the trader enters into in order to take advantage of her/his beliefs.

Chapter 5 55


Table 5.16

A Reverse Crack Speculation Date

Futures Market

March 16

Sell 1 JUL heating oil contract at $.5185 per gallon. Buy 1 JUL crude oil contract at $.4569 per gallon.

June 8 Buy 1 JUL heating oil contract at $.5628 per gallon. Sell 1 JUL crude oil contract at $.5017 per gallon.

Profit/Loss:

Heating Oil: 1 42,000 ($.5185 B .5628) = B$1,860.60 Crude Oil: 1 42,000 ($.5017 B .4569) = $1881.60

Total Gain: $21

The trader’s assessment was correct and thus he/she made a profit.

Chapter 5 56


Table 5.17

A Crack Speculation Date

Futures Market

June 8

Buy 10 JUL heating oil contracts at $.5628 per gallon Sell 10 JUL crude oil contracts at $.5017 per gallon

June 3 Sell 10 JUL heating oil contracts at $.5419 per gallon Buy 10 JUL crude oil contracts at $.4700 per gallon

Profit/Loss:

Crude Oil: 10 42,000 ($.5017 B .4700) = $13,314.00 Heating Oil: 10 42,000 ($.5419 B .5628) = B$8,778.00

Total Gain: $4,536

The trader now believes that the spread will widen, and that heating oil will now rise in price relative to crude. Therefore, she decides to place a crack spread (crack spread consists of buying the refined product and selling crude). Table 5.17 shows the trader’s transactions.

Notice that the trader’s overall profit depends only on the crack spread, not on the direction of oil prices in general.

Chapter 5 57


Product Profile: The CME=s Live Cattle Futures

Contract Size: 40,000 pounds of 55% choice, 45% select grade live steers Tick Size: .025 cents per pound ($10.00/contract) Price Quote: Cents per pound Contract Months: February, April, June, August, October and December.. Expiration and final Settlement: The last trading day is the last business day of the contract month. Physical delivery required. Trading Hours: Open outcry: 9:05 a.m. - 1:00 p.m. Central Time, Monday-Friday.Electronic: 9:05 p.m. - 1:00 a.m. Central Time, Monday.-Friday. Daily Price Limit: 30 cents per pound ($1,200/contract) above or below the previous day's settlement price.


A Time Line for Cattle Production

Chapter 5 58

The Cattle Crush

The cattle crush depends upon the price of cattle today, the expected price of cattle in the future, and the price of grain necessary to feed the cattle to a larger future size.

A popular cross-exchange spread occurs between corn contracts on the CBOT and cattle contracts on the CME.

The cattle crush spread can be established by holding a long position in corn futures while simultaneously establishing a short position in live cattle.

A reverse cattle crush involves buying two live cattle contracts for each corn contract the trader is short.

Chapter 5 59


Example

The owner of the newborn calf sells two futures contracts for the calf:

– One contract for delivery as a feeder in 12 months.

– One contract for delivery against the live cattle contract in 18 months.

The owner has the following options:

– Deliver the calf against the feeder contract, and offset the live cattle contract.

– Offset the feeder contract, maintain the live cattle contract, and deliver the 18 month steer against the live cattle contract.

The owner’s potential profitability is largely a function of the cost of corn.

If feed prices rise, the profitability of feeding is reduced. Thus, spread between the cash price of feeder cattle and the futures price for live cattle will narrow as corn prices rise.

Chapter 5 60

Corn and Live Cattle Future Prices

Assume that today, May 22, you, a cattle feeder, have gathered the information from Table 5.18. You have 65 steers and anticipate that the steers will be on feedlot rations for sixth months in order to produce slaughter weight cattle. You know that one corn contract will feed the steers underlying 2 live cattle contracts to slaughter weight. You calculate your current spread to be $739.46 per steer. You fear that the cattle crush spread may narrow, and wish to lock in the current spread. The ratio of corn contracts to live cattle contracts is 1:2.

Chapter 5 61

Corn and Live Cattle Future Prices

The current spread is calculated as follows:

Value of two cattle contracts:

2(40,000)(.7680) = $61,440 or 945.23 per steer

Value of one corn contract:

1(5,000)(2.675) = $13,375 or $205.77 per steer

The spread is the difference between the value of the cattle contracts and the cost of corn.

Table 5.18

Corn and Live Cattle Futures Prices

May 22

November 22

Contract Size

Method of Quotation

DEC Corn

2.675

2.80

5,000 bu.

$ per bushel

DEC Live Cattle

76.800

76.00

40,000 lbs

per pound

Chapter 5 62

The Cattle Crush Spread Position

Table 5.19

A Cattle Crush Spread Position Date

Futures Market

May 22

Buy 1 DEC corn contract at $2.675 per bushel Sell 2 DEC live cattle contracts at 76.80 cents per pound

November 22 Sell 1 DEC corn contract at $2.80 per bushel Buy 2 DEC live cattle contracts at 76.00 cents per pound

Profit/Loss: Corn: 5,000 (B$2.675 + $2.80) = $625 Live Cattle: 2 40,000 ($.7680-$.7600) = $640

Total Gain: $1,265

Table 5.19 shows the transactions you enter in order to lock in your current spread.

Your cattle crush produce a $1,265 gain.

Chapter 5 63

Reverse Cattle Crush Spread Position

Table 5.20

A Reverse Cattle Crush Spread Position Date

Futures Market

May 22

Sell 1 DEC corn contract at $2.675 per bushel Buy 2 DEC live cattle contracts at 76.80 cents per pound

November 22 Buy 1 DEC corn contract at $2.80 per bushel Sell 2 DEC live cattle contracts at 76.00 cents per pound

Profit/Loss: Corn: 5,000 ($2.675 - $2.80) = -$625 Live Cattle: 2 40,000 (-$.7680 + $.7600) = -$640

Total Gain: -$1,265

Now assume that you believe that the corn/cattle spread will widen. Therefore, to take advantage of your belief, you establish a reverse cattle crush spread.

Table 5.20 shows the results of a reverse cattle crush using the prices displayed in Table 5.18.

You miscalculated. As the spread narrowed, your reverse cattle crush position in the futures market lost $1,265.

Chapter 5 64

Hedging

Chapter 4 explored hedging and basic hedging strategies. This section explores more complicated strategies particular to:

– Energy markets

– Agricultural markets

– Metallurgical markets

We consider hedging different grades of oil.

Two highly publicized cases of improperly implemented hedges will also be explored.

Chapter 5 65

Hedging Worldwide Crude Oil

There are different kinds of crude oil originating around the world. The following table illustrates six types of oil.

Types of Oil Designation

Description

WTI West Texas IntermediateBMidland

Brent North Sea oil

ANS Alaskan North Slope oil

Forcados Nigerian oil

Dubai Arab light oil

Urals Soviet oil

Chapter 5 66


Recall that the easiest way to compute the risk-minimizing hedge ratio, number of futures contracts to hold for a given positions in a commodity, is by estimating the following regression:

ttttt FFSS )()( 11

From the previous regression:

β = The risk-minimizing hedge ratio

Α = A measure of hedging effectiveness

Where

10 2 R

The closer to 1, the better the chance that the hedge will work.

Chapter 5 67


Table 5.21 reports the volatility of the weekly price changes for the different oils and the results from two hedging strategies.

Table 5.21

Results for Crude Oil Hedging Oil

Weekly σ

($ per barrel)

R2

1:1 Hedge

RiskBMinimizing

Hedge Ratio

R2 Risk

Min. Hedge WTI

.8407

.8462

.9991

.8462

Brent

.8238

.5779

.8272

.6042 ANS

.8433

.8284

.9961

.8285

Forcados

.7500

.5010

.7351

.5758 Dubai

.7049

.2959

.6227

.4676

Urals

.6699

.2553

.5956

.4738 Source: Gordon Gemmill, AHedging Crude Oil: How Many Markets Are Needed in the World?@ The Review of Futures Markets, 7, 1988, pp. 556B571.

Finding a futures contract that closely matches the spot commodity is important and will generally improve the hedge considerably.

Second, for cross-hedges, the naive 1:1 hedging approach may be markedly inferior to using a risk-minimizing hedge ratio.

Chapter 5 68

Improperly Implemented Hedges

Two highly publicized cases of improperly implemented hedges were:

The Hedge-To Arrive (HAT) Fiasco

Agricultural commodities

The Metallgesellschaft Hedging Fiasco

Energy Products

chapter 51 chapter 5 agricultural, energy and metallurgical futures contracts this chapter explores...

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