“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:
- 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)
- 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)
- “Crack” Spread
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 the Canvas Modules under Lesson 10: 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).