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 1
 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 2
 Commodity Characteristics

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 3
 Commodity Characteristics
Supply and Storability

Insert Figure 5.1 here

Chapter 5 4
 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 Grains and oilseedsCexpect de-
fluctuations in stocks partures from full carry.
Good Consumption cycle causes Energy productsCexpect depar-
fluctuations in stocks tures from full carry.
Poor Low, largely due to poor LivestockCexpect frequent depar-
storability tures from full carry.

Chapter 5 5
 Commodity Characteristics

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 6
 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.

Insert Figure 5.2 here

Chapter 5 7
 Full Carry Markets Precious Metals

If gold is a full carry market, the following relationship

should hold:

F 0, d  F 0, n(1  C )
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:

DEC gold futures

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

Any time this equation equals something other than zero,

an arbitrage opportunity is possible.

Chapter 5 8
 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 9
 A Full Carry Example: Gold

DEC gold futures

-1 = 0
JUN gold future (1 + C )
442.60
- 1 = .000804
426.00(1.038132)

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.

F0,d  F0,n 1  c 

Profit  F0,d  F0,n 1  c 

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

Chapter 5 10
 A Full Carry Example: Gold

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

F 0, t
 1  C 0, t
S0
$442.60
 1 = 0.038967
$426.00

The futures contract is for ½ year, so to compare this

rate to the T-bill rate, we must annualize it as follows:

Annual Rate  1  0.038967   1

2

Annual Rate  7.9453%

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.

Chapter 5 11
 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 12
 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 13
 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 14
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 15
 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 16
 Departure from Full Carry:
Silver

Insert figure 5.4 here

Chapter 5 17
 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 18
 Inventories and Price Patterns

Insert Figure 5.5a Here

Insert Figure 5.5b here Insert Figure 5.5c here

Chapter 5 19
 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 20
 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 21
 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 There are various harvest times which
to harvesting patterns. 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 22
 Seasonal Character of Cash Wheat
Prices

Insert figure 5.7 here

Chapter 5 23
 Wheat and Wheat Futures

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
Percentage Change
Stock (from preceding
Month (millions of bushels) 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 24
 Wheat and Wheat Futures

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 25
 Wheat and Wheat Futures

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 26
 Wheat and Wheat Futures

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 Number of
Months Months
Futures Rose 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 27
 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 28
 Wheat Versus Gold:
The Cost-of-Carry Model

Insert Figure 5.2 Insert Figure 5.8 Here

JUL and DEC Gold Futures JUL and DEC Wheat Futures
Prices Prices

Chapter 5 29
 Wheat Versus. Gold:
The Cost-of-Carry Model

Insert Figure 5.9 here

Deviations from Full Carry for Wheat

Chapter 5 30
 Wheat Versus Gold:
The Cost-of-Carry Model

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

Stronger trend to deviate from full Almost always at full carry.

carry (first below full carry, and later
above full carry).

Distant futures exceeded the nearby Distant futures never exceeded the
futures plus financing cost. nearby futures plus financing cost.

Storage, insurance and transportation Financing cost is a significant carrying

are more significant carrying costs). cost.

Chapter 5 31
 Wheat Versus Gold:
The Cost-of-Carry Model

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 32
 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 33
 Crude Oil Futures Prices

Table 5.7
Crude Oil Futures Prices for March 21 of Various Years
Contract Expiration Year
Expiration 1984 1985 1986 1987 1988 1989 1990
Month
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 34
 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 35
 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: CALF
Conception to weaning

II PHASE: FEEDER
CATTLE
Feeding ≈1 yr
Weight ≈ 600-800 Lbs

No Yes

TRADE III PHASE: LIVE

Feeder Cattle Grow CATTLE
More Weight ≈ 1050-1200 Lbs

Chapter 5 36
 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.

Insert figure 5.10 here

Chapter 5 37
 Commodities with Poor Storability
Live Stock

Insert figure 5.11 here

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 38
 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 39
 Intra-Commodity Spreads

Recall: the Cost-of-Carry Model for a full carry market

with perfect markets.

F0,d  F0,n 1  c 
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 40
Bull and Bear Intra-commodity Spreads

Table 5.9
Bull and Bear IntraBCommodity Spreads
Bull Spread Bear Spread Commodities
Short nearby Long nearby Full Carry Markets
Long distant Short distant Gold, silver, platinum, palladium,
financials
Long nearby Short nearby NonBFull Carry Markets
Short distant Long distant Cocoa, copper, wheat, corn, oats,
orange juice, plywood, pork bellies,
soybeans, soymeal, soyoil, sugar

Chapter 5 41
 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 42
 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 43
 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 contracts
55,000 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 44
 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 Short soybeans of one expiration; long
spread soymeal and soyoil for the next expiration.

Chapter 5 45
 Soybeans and Crush Spreads

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 8.6600 7.8525 8.1700
bushel)
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 46
 Soybeans and Crush Spreads

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 47
 Soybeans and Crush Spreads

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.

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

Bean prices rise causing the speculator another net

loss of $13,013.

Chapter 5 48
 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 49
 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 50
 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 gasoline
1 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 51
 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 52
 Oil and Crack Spreads

Insert Figure 5.12 here Insert Figure 5.13 Here

JUL Crude and Heating Oil Spread between JUL Heating

Futures and Crude Oil Futures

Chapter 5 53
 Oil and Crack Spreads

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
Crude Oil Heating Oil Crack
Date ($ per gal.) ($ per gal.) 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 54
 Oil and Crack Spreads

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 55
 Oil and Crack Spreads

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.

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

Notice that the trader’s overall profit depends only on the

crack spread, not on the direction of oil prices in general.

Chapter 5 56
 Feeder Cattle and Live Cattle

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.

Insert Figure 5.14 here

A Time Line for Cattle Production

Chapter 5 57
 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 58
 Feeder Cattle and Live Cattle

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 59
 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 60
 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 61
 The Cattle Crush Spread Position

Table 5.19 shows the transactions you enter in

order to lock in your current spread.

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

Your cattle crush produce a $1,265 gain.

Chapter 5 62
 Reverse Cattle Crush Spread Position

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.

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

You miscalculated. As the spread narrowed, your reverse

cattle crush position in the futures market lost $1,265.

Chapter 5 63
 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 64
 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 65
 Hedging Worldwide Crude Oil

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:

( St 1  St )     ( Ft 1  Ft )   t

From the previous regression:

β = The risk-minimizing hedge ratio
Α = A measure of hedging effectiveness
Where
0  R2  1

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

Chapter 5 66
 Hedging Worldwide Crude Oil

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
2 2
Weekly σ R RiskBMinimizing R Risk
Oil ($ per barrel) 1:1 Hedge Hedge Ratio 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 67
 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 5 68