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Is hedging the crack spread no longer all it's cracked up to be?

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  • Liu, Pan
  • Vedenov, Dmitry
  • Power, Gabriel J.

Abstract

The traditional approach to hedging the crude oil refining margin (crack spread) adopts a fixed 3:2:1 ratio between the futures positions of crude oil, gasoline, and heating oil. However, hedging the latter in arbitrary proportions might be more effective under some conditions. The paper constructs optimal hedging strategies for both scenarios during the periods of relatively stable and volatile oil prices observed in recent years. Minimization of downside risk (LPM2) and variance are used as alternative hedging objectives. The joint distribution of spot and futures price log returns is modeled using a kernel copula method. The hedging performance of the constructed strategies is compared using hedging effectiveness, expected profit, and expected shortfall. The results show that allowing for arbitrary proportions in the sizes of futures positions generally achieves a better hedging performance. The advantage becomes particularly important during periods characterized by greater variation of the cross-dependence between the price log returns of individual commodities. In addition, using LPM2 as a hedging criterion can help hedgers to better track downside risk as well as lead to higher expected profit and lower expected shortfall.

Suggested Citation

  • Liu, Pan & Vedenov, Dmitry & Power, Gabriel J., 2017. "Is hedging the crack spread no longer all it's cracked up to be?," Energy Economics, Elsevier, vol. 63(C), pages 31-40.
  • Handle: RePEc:eee:eneeco:v:63:y:2017:i:c:p:31-40
    DOI: 10.1016/j.eneco.2017.01.020
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    References listed on IDEAS

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    Cited by:

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    3. Shrestha, Keshab & Subramaniam, Ravichandran & Peranginangin, Yessy & Philip, Sheena Sara Suresh, 2018. "Quantile hedge ratio for energy markets," Energy Economics, Elsevier, vol. 71(C), pages 253-272.
    4. Sukcharoen, Kunlapath & Leatham, David J., 2017. "Hedging downside risk of oil refineries: A vine copula approach," Energy Economics, Elsevier, vol. 66(C), pages 493-507.

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    More about this item

    Keywords

    Crude oil; Crack spread; Gasoline; Futures; Downside risk; Hedging; Copula; Risk management; Dependence;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • Q40 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - General
    • Q41 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Demand and Supply; Prices
    • Q47 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Energy Forecasting

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