EBF 301
Global Finance for the Earth, Energy, and Materials Industries

Mini-Lecture: Financial Energy Spreads


“Spread” trading can be used for hedging purposes or purely for trading (“arbitrage”). This involves using price differences in futures or forwards based upon time differences, locational differences and inter-commodity relationships.

In spread trading, futures or forwards can be used to achieve the desired results. A buy/sell is offset by a corresponding sell/buy. Examples of the types of spreads are:

  1. Time Spread (often called a “storage” spread)
    • Buy a natural gas contract in May/sell it in January
    • Buy a heating oil contract in April/sell it in December.
  2. Locational Spread
    • Buy NYMEX crude (WTI) contract/sell Brent (North Sea) crude contract
    • Buy NYMEX Henry Hub natural gas/sell a different cash market Hub ("Basis" value)
  3. Inter-commodity Spread – Buy/Sell differing but related commodities
    • “Crack” Spread
      • Buy crude oil/sell heating oil or gasoline (HO/RBOB is “cracked” from CL)
    • “Frack” Spread
      • Buy natural gas/sell Propane (midstream natural gas companies process natural gas into Propane and other NGLs)
    • “Spark” Spread
      • Buy natural gas/sell electricity (electric generators can use natural gas to produce power)

In addition to traders who are merely interested in price movement to make money, commercial entities can use Spreads to hedge their price risk. For example, as mentioned above, a crude oil refiner can buy crude contracts (hedge price of feedstock) and sell heating oil and unleaded gasoline contracts (refined output) to establish a profit margin or “crack” spread. This hedge is illustrated in the spreadsheet, "EBF-301 Lesson 9 refinery hedge.xls" found in the Canvas Modules under Lesson 9: Advanced Financial Derivatives - Swaps, Spreads, and Options.

The following Mini-Lecture summarizes the points presented above.

Key Learning Points for the Mini-Lecture: Financial Energy Spreads

  • Spreads are merely price differences between commodities that are interrelated somehow, have differing locations, or represent different months of the same commodity.
  • They are traded together for hedge purposes (reduce price risk) or outright trading (speculate on price spread movement).
EBF 301 Lesson 9 Spreads
John A. Dutton e-Education Institute