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

Financial Energy Spreads


“Spread” trading can be used for hedging purposes or purely for trading (“arbitrage”).  Spread trading involves taking a long position in one futures contract and simultaneously taking a short position in another, related futures contract. Thus, spread consists of two equal and opposite futures positions. In spread trading, futures or forwards can be used to achieve the desired results. A buy/sell is offset by a corresponding sell/buy. Spread trading involves using price differences in futures or forwards based upon inter-market (time differences, locational differences) and inter-market commodity relationships.

Examples of the types of spreads are:

  1. Inter-market (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).
  1. Intra-market (intra-commodity) Spread – Buy/sell same commodities
    • 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.
    • 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).

    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 10 refinery hedge.xls" found in Canvas Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options Module.

    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 representing different months of the same commodity.
    • They are traded together for hedge purposes (reduce price risk) or outright trading (speculate on price spread movement).

    The following mini-lecture summarizes the points presented above (6:10 minutes).

    EBF 301 Lesson 10 Spreads
    Click here for the transcript.

    Moving on to the next part of our discussion of advanced financial derivatives, we're talking about spreads. Again, I've got some extensive notes and some examples in the lesson content, but we'll review these concepts here in these slides.

    OK, Spread trading itself-- here we're talking about trading-- it's a technique that takes advantage of the relative price movement between futures contracts. Arbitrage, that's a simultaneous purchase and sale of similar or identical commodities in two different markets in hopes of gaining a profit from the price differential. Now again, with spread, we're not dealing so much with price as we are dealing with the price differences. Margin requirements are considerably lower than the requirements on single futures contracts, because again, the exposure is the spread difference-- the difference between the price is not one singular price. So that also makes them less risky than outright futures positions. You're exposed to this movement in the spread, either the spread widens or the spread gets tighter, as opposed to the price of the futures contracts themselves.

    Here are some simple rules. This is for trading spreads for speculative purposes. Rule 1 is, if you think spreads are going to narrow, you buy low, and you sell high currently. So, you buy the lower price, and you sell the higher price to set a spread. And then, when the prices do, in fact, narrow based on your expectations, you'll be able to go ahead and liquidate that spread at some profit. Otherwise, if the spreads are expected to widen, you expect the price difference to get greater, you will buy the high contract now and sell the lower of the two.

    Different types of spreads-- one is the Inter-market. Now, this is the simultaneous purchase and sale of different, but related, commodities that have a reasonably stable relationship to each other. So, inter-market, keep in mind, inter-market means different commodities, not the same commodity. So, we have some different types of spreads and these are the commonly used terms for these spreads.

    We have what's known as a Crack Spread. OK, this would be crude oil versus unleaded or heating oil. Now, if you think back to the lesson on crude refining, you have a process by which you are actually cracking the hydrocarbon molecules and then reforming them into these other products, so that's why you get this name here. Crude being the feedstock, and the refined products being unleaded and heating oil. And all three of these trade on the New York Mercantile Exchange. Therefore, these can be used to hedge the spread that refiners are exposed to.

    A Spark Spread, it's natural gas versus electricity. Again, this would pertain strictly to natural gas fired power plants. Heating oil versus gas oil-- again, this one can be broken down into another, so we can use this spread. NYMEX versus ICE. Now, this is on crude oil spreads. Here, we have a situation where we're actually using inter-markets. The markets are the different trading platforms. So, savvy traders can sit there and look at NYMEX prices and Intercontinental Exchange Prices for crude oil, and they can take advantage by buying one and selling another, or selling one and buying another electronically.

    And then we have a Frac Spread, and this is not to be confused with fracking, which is a completion method for oil and gas wells. What we're talking about here is, again, if you think back to the lecture on processing, the processing plants take natural gas and convert it to natural gas liquids or the so-called fractions using a fractionation tower. And so, that's where we break down and get the ethane, propane, butane, isobutane, natural gasoline, and condensate. So, since natural gas is the feedstock for a processing plant, and the natural gas liquids are the output from that plant, we can put on a frac spread to hedge those differences.

    The other type of spread is Intra-market, and this is also known as an intra-commodity spread. The idea here is we are using the same commodity, but we are trading things like time or location. So, a time spread is the simultaneous purchase and sale of futures contracts on the same commodity for different delivery months. So, for example, we could buy August 2015 natural gas contracts and sell the January 2016 natural gas contracts. This would be a storage spread, because the idea would be we would buy the August contracts, put that gas in the ground in August, and then turn around and sell the January contracts, and take the gas out then. So, that difference in price between August and January represents our storage spread.

    Then we also have Locational Spreads. This would be the simultaneous purchase and sale of futures contracts for different locations. So, for instance, in terms of crude, we could use the WTI versus the Brent crude pricing. And for natural gas, we could use Henry Hub versus, say for instance, New York City. And here's an example of an intra-market spread for natural gas. Again, as I've mentioned right here, in this example, we're going to talk about August 2015 versus January 2016 at these respective prices.

    So, if you think spread's are going to narrow, in other words, we start up $2.90 versus $3.25, so we have a $0.35 spread, if you think that that spread is going to become less, you're going to buy the low, which is the $2.90 and sell the $3.25, which is the high. And then, if you think spread's is going to widen, that is that the price difference between these two months is going to end up being greater than for $0.35, you're going to sell the lower priced, $2.90, and you'll buy back the $3.25. Now, again, keep in mind this is for speculative trading, trading for pure profit. This is not a hedging type of plan or scenario.

    Credit: John A. Dutton e-Education Institute

    If one wishes to enter into a contract for underground storage capacity, this transaction can be hedged as well using the time spread.

    Example of Time Spread:

    Let’s look at an example. The April 2020 NYMEX natural gas contract is trading $2.65 at the time of this writing. We can buy these contracts and that will represent the supply that we would inject into storage in April 2020. Now, we need a market for when we wish to withdraw these same volumes. January 2021 is trading at $3.98, so we would sell the January 2019 futures contracts in the same amount as we bought in April 2020. This creates a “spread” of $0.33. After the respective monthly storage fees are taken-out, we are left with the “net” spread on our storage transaction. This is also known as a “time spread” since it involves a purchase and sale of the same commodity in differing months.

    These simple, “fixed-price” hedges are the basic building blocks for more complex financial derivative hedges.