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kets, whidi may be of different delivery months, depending on the processing time. The most common product spreads are:

Resulting primary product(s)

Raw pmduct(s)

Soybeans Crude oil

Feeder cattle and grain Feeder pigs and com Live hogs

Meal and oil

Gasoline and #2 heaong oil Fat catde Live hogs Pork bellies

Exchanges often allow reduced margins when these spreads are entered in the proper proportion at the same time.

FIGURE 13-3 A comparison of U.S.Treasur3 bond yields and the CRB Index, 1987-1993. A very similar trend is disrupted by an occasional large divergence. In most cases, a noticeable rise or fall in the CRB Index is followed by a change in interest rates in a manner intended to offset the effects of inflation.

Source: Charts created with »1 £( »1® by Omega Research, Inc.

Product spreads do not alwajs correct for distortions witiiin tlie time needed to be profitable for the trader, \ien the combined on sojlsean meal and oil is below the cost of crushing the sojlseans, processors may execute a reverse soybean crush spread, in which they sell the soybeans and buy the products. Even though this sppears to be a clever way of keeping prices in-line, it is not done until the crushing margin is very negative. Processors cannot readily reduce their level of operation and lay off emfrtoyees; a reverse crush means that they are buying products as well as producing them-a position of significantly increased risk.

The Crack Spread

Crude oil is refined primarily into gasoline and heating oil. As with the soybean crush, where the processor bujs soybeans and produces meal and oil, the refiner expects a profit from the business of bujing crude oil and selling gasoline and heating oil. A speculator can theoretically participate in this process by bujing crude oil and selling the products in the right proportion and in the correct delivery months. For example, if crude oil was frading at $20 per barrel, heating oil at 52.400 per gallon, and gasoline at 59.50- per gallon, then based on fiitures confrcts of 1,000 barrels of crude and 42,000 gallons of heating oil and gasoline, we could calculate each confract value:

Gasoline component: 59.50 x 42,000 = $24,990 Heating oil component: 52.40 x 42,000 = $22,008 Total components: $46,998

Crude oil component: 20.00 x 1.000 = $20.000 Two other important fads are necessarj to put this frde together:

1. It takes from 4 to 6 weeks to refine crude oil into its products; therefore, the prices used in the crack spread should alwajs take the product prices quoted 1 month after the crude price

2. While the refining ratios can varj during the year, based on the higher demand for gasoline in the summer, and the higher demand for heating oil in the winter, the standard ratios are found in Table 131.

Although there are many other by-products of the refining process, the major components of fuel oil and gasoline are produced in a ratio of slightly more than two parts gasoline to one part fuel oil on average each year. This ratio then accounts for the 3-2-1 crack spread, in which three confrads of crude oil are bought, and two confrads of gasoline and one confrad of heating oil are sold. In the example above, we can complete the net transadion as follows:

Sell! Sell! Bux3

Morfcel Gasoline contracts Heatrni oil contract Crude oil contracts Net transaction (without costs)

59.50 x 42.000 = 52.40 x 42.000 = 20.00x1.000 =

Value

Total Units Cost

$24.990 x 2 = $49.980 $22.008x 1 =$22,008 $20.000 x 3 = J60.000 $11.998

Transaction costs will include the expectation of buying crude oil higher and selling products lower than desired when the hade is entered, the commission, and the cost of holding the conhacts until delivery

TABLE 13-lFuel Oil and Gas Production and Ratios, 1984-1992

Fuel Oil Case!

1984 981 326 I.I07 2.171 414 42 2.827

1985 981 322 1.303 2.352 434 34 2.820

1986 Ij02l 324 1.345 2,476 472 J3 2.981

1987 997 323 1.320 2.S06 490 29 3,025

1988 1.046 ]39 I.3SS 2.555 501 29 3.085

1989 I.IS2 SOO I.6S2 2.684 544 31 3,2S9

1990 1.067 347 1.414 2,650 5S5 16 3,222

1991 1 »1 341 1.422 2,554 525 14 2.820

1992 I.08B 326 1.414 2.591 512 15 3.118

Reverse Crack

\ien the delivered price of the produas totals to less than the cost of crude oil. the refiner has no reason to process the crude oil, and can go to the market to buy the products and sell crude. This is called a reverse crack, in reality, processors can perform a reverse crad; to some degree, but shutting down operations to accommodate a temporary market condition is not a good policy The process of shutting down and restarting a large refinery is nol simple, and labor problems make matters more complicated. \ien executing a reverse crack, the same delivery months are used for both crude and products.

CHANGING SPREAD RELATIONSHIPS

Some spread relationships will alwajs exist, while others may change due to:

1. Price level, such as during the silver bull market of 1980

2. Consumer tastes, such as a shift away from red meat

3. Health reasons, such as those often concerning nifrates in bacon

4. New competition, such as increased supply of edible oils from the Far East impacting the soybean product relationship, or the effect of high-fiiictose com sweeteners on the sugar industrj

Even though the maricet absorbs the anticipation of change in an orderiy way. unexpected events relating to health or interruption of supply can produce a price shock that will affect many spreads.

Gold/Silver Ratio

A relationship that has alwajs been followed with keen interest is the gold silver ratio, fraditionally considered normal at 33 : 1. It serves as a good example of the variability- of many perceived spreads. When gold was $35 per ounce and silver about SI per ounce, the relationship was never very stable. Between 1930 and 19-15, silver prices dropped to about $.50 per ounce; from 1951 to 1962, they remained just under SI per ounce, and afterward silver began its accelerating move to $38 per ounce in.lanuan-1980. Between 19-1-1 (when the Intemational Monetarj Fund (IMF) was formed) and 19-1. the price of gold -was fixed at $35 per ounce, although in a few years before the cancellation of the agreement, the price varied above the designated value. From the late 1960s until the silver crisis of 1980. the gold/silver ratio ranged from about 20 : 1 to 45 : 1 in a slow cycle. During the crisis atfributed to the Hunt brothers (September 1979-September 1980), the ratio fluctuated around 33 : 1 in a highly volatile pattem moving only slightly above and below its historic pattem. Following the silver crisis, the value of silver declined faster than gold, reaching a ratio of 56 1 in June 1982, with gold at S314 and silver at $5.57. A year later, the ratio touched 33 1 and rapidly widened to 66 : 1 in June 1986.