Commodity Option Pricing: A Practitioner's Guide

6 Energy II – Refined Products

Whereas coal and natural gas can be consumed directly, crude oil is a complex mixture of different hydrocarbons, and not generally used in its raw form.¹ The process of extracting different types of hydrocarbons of similar molecular weights is known as “cracking” and is how we arrive at the refined oil products that end users like, as all of us take for granted in our everyday lives, such as gasoline/petrol,² diesel, heating oil, jet fuel, etc. Many people wonder why the price of fuel at the pump doesn’t rise (or fall!) in line with crude oil prices – the answer to this is that only about half of the retail price of a gallon of gasoline in the USA is directly linked to the cost of the crude oil required to make it; 20% comes from taxes, about 20% from the cost of the refining process and the remaining 10% or so comes from distribution and marketing. The proportion of taxes is certainly higher in various other countries.

While the financial market for crude oil completely dominates the market for refined oil products, some commentators³ predict that futures and options on refined oil products will increase in importance between 2013 and 2018.

In this chapter, we describe the refined oil products that are typically extracted from crude oil, and relate these to the financial markets that exist on these products. We discuss what makes these behave differently from crude oil, and finally we mention the financial products that relate refined oil products ...