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Given the emerging consensus from previous studies that crude oiland refined product (as well as crack spread) prices are cointegrated, thisstudy examines the link between the crude oil spot and crack spreadderivatives markets. Specifically, the usefulness of the two crack spreadderivatives products (namely, crack spread futures and the ETF crack spread)for modeling and forecasting daily OPEC crude oil spot prices is evaluated.Based on the results of a structural break test, the sample is divided intopre-crisis, crisis, and post-crisis periods. We find a unidirectionalrelationship from the two crack spread derivatives markets to the crude oilspot market during the post-crisis period. In terms of forecastingperformance, the forecasting models based on crack spread futures and the ETFcrack spread outperform the Random Walk Model (RWM), both in-sample andout-of-sample. In addition, on average, the results suggest that informationfrom the ETF crack spread market contributes more to the forecasting modelsthan information from the crack spread futures market.
In this study, we explore the link between the crude oil spot andrefined product derivatives markets and examine the ability of the refinedproduct derivatives prices to predict movements in the crude oil price. Inoil and energy markets, the profits of oil refiners, the major participantsin the markets, depend largely on the crack spread (the difference betweenthe price of crude oil and the prices of refined products--typically gasolineand heating oil). Because the demand from oil refiners, whose productiondecisions are tied directly to the crack spread, largely affect the price ofcrude oil (Verleger, 1982; Verleger, 2011), it is possible that there is along-run equilibrium relationship between crude oil and crack spreadderivatives prices. This study therefore examines the existence of long-runequilibrium price relationships between the crude oil and crack spreadderivatives markets. Specifically, we explore the equilibrium pricerelationships between (i) the OPEC crude oil spot and crack spread futuresand (ii) the OPEC crude oil spot and Exchange Traded Fund (ETF) crack spread.The Granger causality is then used to analyze the lead-lag relationship anddetermine whether the crack spread derivatives prices are useful forforecasting the movements of crude oil spot prices. Finally, we compare theforecasting ability of the two crack spread derivatives with that of aconventional Random Walk Model (RWM).
Our paper contributes to the existing literature by enriching theunderstanding of the dynamic relationships between crude oil spot and refinedproduct derivatives prices in the following ways. First, unlike many previousstudies, we focus on the prices of crude oil spot and crack spreadderivatives. With the notable exception of Murat and Tokat (2009), our studyis among the first to examine the link between the crude oil spot and crackspread derivatives markets and to investigate oil price forecasting modelsbased on information from the crack spread derivatives markets. Unlike Muratand Tokat (2009), we analyze not only the futures market but also the ETFmarket. Thus, the findings from this study also have implications regardingwhich market contributes more to the forecasting models. In addition, whileMurat and Tokat (2009) ignore the presence of heteroskedasticity in theresiduals, we correct for the time-varying nature of the variance andcovariance of commodity prices and returns by utilizing a Multivariate GARCH(MGARCH) model. Second, whereas most of the previous literature, includingMurat and Tokat (2009), focuses on either Brent or West Texas Intermediate(WTI) crude oil prices, we investigate the dynamics of the new OPEC ReferenceBasket (ORB) price. The understanding of the OPEC crude oil price isimportant given the share of OPEC's crude oil production and exports.The U.S. Energy Information Administration (2014) reports, "OPEC membercountries produce approximately 40 percent of the world's crude oil andexports approximately 60 percent of the total petroleum tradedinternationally"' In particular, the study allows us to answerwhether the crack spread price data from the U.S. derivative markets cansignificantly explain OPEC crude oil price movements. In summary, given thelimited empirical investigations of the link between the OPEC crude oil spotand refined product derivatives markets, the results from this study shouldprovide useful information for both oil refiners and energy investorsregarding portfolio investment and risk management.
The remainder of this paper is organized as follows. Section 2contains a brief discussion of the theoretical background on predicting oilprice movements using crack spread derivatives. Section 3 describes the data.Section 4 presents the methodology used in forming the forecasting models.Section 5 discusses the empirical results, and finally, Section 6 concludes.
The idea of forecasting oil price movements using information fromthe crack spread futures market is based on two different arguments. Thefirst argument relies on the proposition that the price of crude oil largelydepends on the demand from oil refiners (Verleger, 1982; Verleger, 2011). Therationale behind this proposition is that oil refiners are most concernedwith the crack spread, and therefore, they cut their levels of productionwhen the price of crude oil is too high compared with the prices of theirrefined products (i.e., when the crack spread is too low). A decrease inproduction of refined products will, in turn, lower the price of crude oilthrough the lower demand for input (Verleger, 2011). This relationshipsuggests that we should be able to forecast future oil price movements basedon information from the crack spread markets. Assuming that the efficientmarket hypothesis holds, then the prices of futures contracts based on crackspreads are the optimal forecasts of the crack spreads (e.g., Chinn &Coibion, 2014; Lean, McAleer & Wong, 2010; Ma, 1989). Accordingly,information contained in crack spread futures should at least partiallyexplain future oil price movements.
The second argument relies on the proposition that there is apositive relationship between convenience yield (the benefit from physicallyholding a commodity rather than holding a futures contract for thatcommodity) and marginal production costs (Heinkel, Howe, & Hughes, 1990).The reasoning behind this proposition is that, to maximize their profits, oilrefiners respond to increased demand through immediate production when themarginal production costs are low and through the stock kept in inventorywhen the marginal costs of production are high. This strategy implies thatwhen the marginal production costs are relatively inexpensive (expensive),the convenience yields are low (high). Because low marginal costs imply highprofit margins or crack spreads, the proposition therefore suggests thatthere is a negative relationship between the convenience yields and crackspreads. This negative relationship is empirically verified by Edwards and Ma(1992) and Kocagil (2004). Given the Theory of Storage (Kaldor, 1939),commodity spot prices and commodity futures prices are related through theconvenience yield. Thus, assuming the efficient market hypothesis, one shouldexpect the existence of a long-run equilibrium relationship between crude oilspot and crack spread futures markets and that variations in crack spreadfutures can help explain crude oil price movements (see, for example, Ascheet al., 2003; Gjolberg & Johnsen, 1999; Haigh & Holt, 2002; Lanza etal., 2005; Murat & Tokat, 2009; Seletis, 1994).
Instead of relying solely on crack spread futures, the recentintroduction of derivative-based ETFs allows oil refiners and investors tocapture crack spread changes by purchasing equal units of the ProSharesUltraShort DJ-UBS Crude Oil ETF (SCO), the United States Gasoline Fund (UGA)and the United States Heating Oil Fund (UHN) for the 2:1:1 crack spread(which refers to an approximation of the profit margin that oil refiners earnby turning two barrels of crude oil to one barrel of gasoline and one barrelof heating oil) because the price of the SCO fund represents the cost ofpurchasing two units of oil, where the values of the UGA and UHN funds arethe proceeds derived from selling one unit of the respective distillate.Because these funds basically attempt to track the movements of the nearbyfutures, forwards, options and swap contracts, a positive relationshipbetween crack spread futures and the ETF spread can be expected.Specifically, during the period from January 2009 to December 2011, thecorrelation coefficient between the daily prices of crack spread futures andthe ETF crack spread is 0.9061. Figure 1 clearly shows that the price of theETF crack spread tracks the price of the crack spread futures fairly well(though they are not exactly the same). Given the positive relationshipbetween the two crack spread derivatives, the ETF crack spread should alsocontain useful information about future oil price movements. Because theentry barrier in the ETF market is not as strict as in the futures markets,more diverse types of investors (i.e., not only oil refiners andinstitutional investors) can enter the ETF market, which raises the questionof whether the ETF crack spread is better at explaining spot oil pricemovements than the crack spread futures. Given the recent increased investorinterest in oil and refined product ETFs and the convenient trading system,we expect that the ETF market should contribute more to the forecastingmodels. To the best of our knowledge, no empirical research has yet directlyaddressed the role of the ETF crack spread in predicting the movements of thecrude oil spot price. Therefore, this paper examines the forecasting power ofboth crack spread futures and crack spread ETFs for the first time. 2ff7e9595c
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