“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:
- 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).
- “Crack” Spread
- 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).
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.