HO and CL - Manufacturing Chain Correlation
Heating Oil is refined from Crude Oil so
the 99.1% correlation over the last 15 years is not unexpected.
According to an
by the Department of Energy,
the cost of Heating Oil divides into 42% for the raw Crude Oil, 12% for
the refining, and 46% for the distribution/marketing.
Since the refining and distribution businesses are quite competitive
and efficient, their contribution to the volatility in
Heating Oil is generally quite small when compared with the huge
volatility in the Crude Oil market generated by geo-politics.
There are a few features of the
which are interesting.
The large spike in the green line
in 2005 coincides with the impact of Hurricane Katrina which impacted
offshore drilling in the Gulf of Mexico and the oil refineries.
There are at least three reasons why it did affect the hedge so
The refining relationships compounded the uncertainty of the price.
Heating Oil merchants had to worry both that the raw material would
cost the refiners more and that the lower
production capacity of the refineries might create shortages.
Whether the refineries would bring older obsolete equipment back online
or whether foreign refineries with higher
production costs would have to be used was not known.
In this case, the uncertainties were also disproportionate.
The affected refineries represent a larger percentage of the refinery
capacity than the offshore drilling represents
as a percentage oil production.
The expected downtime for the refineries was expected to be more than
for the drilling rigs.
A refinery is a complex chemical processing plant involving many
interconnected custom/low-production-volume parts.
The drilling industry was strong enough that there were plenty of
replacement equipment production capacity.
The resulting expected decline in inventories was thus expected to be
much higher for Heating Oil than for Crude Oil.
Another interesting feature in the
Most years, the price of Heating Oil
up to reach a high point in August.
This coincides with consumers stocking up on oil for the winter.
Some consumers lock in the price at this point and buy a full winter's
worth of oil, but many buy a smaller amount
with the intention of restocking as needed.
With the buying pressure off by October, the price of Heating Oil
By December the uncertainty of winter has abated, and the distribution
chain is looking at
inventory which it must now hold for 8 months.
The price, on average, stays low for until February.
Then over the spring and early summer, the price rises again for the
This seasonal pattern is rarely
interrupted, and reflects, perhaps, the carrying costs for the
At the end of the winter, the customer could buy their oil much
cheaper, but they would have to pay earlier
and bares the risks of having the oil leak.
Since the costs of capital for a leveraged futures position are so
small, there is the potential to profit
from both sides of this cycle.
One could buy the HO future and sell the CL future in the spring, and
sell the HO future short and buy the CL future
long in the early part of winter.
One need merely follow the green signal line.
Using the Channel Breakout system provided within
Unfair Advantage, this spread backtests to return a 24.1% average annual profit on
minimum account equity with a Sharpe ratio of 0.75.
For those with Unfair Advantage,
for information about how one can trade this spread.