Hedging 201 – Part One: Forward Curve Structure
Hedging 101 was our attempt to answer some of the many questions we have received about hedging over the years. Our goals in that series were to “keep things simple” while also providing the building blocks to understand basic hedging concepts in action.
Hedging 201
In this series, Hedging 201, we would like to take things a little farther, exploring important topics like understanding market spreads and how using different financial tools can benefit your business. This brings us to our first topic: forward curve structure.
Forward Curve Structure
Those of you who have been following us for awhile may already understand the concept of a forward curve as it relates to commodities. Whether agricultural or energy, the structure of the forward curve helps to tell the story of that commodity.
Telling the Commodity’s Story
Often the daily price movement in propane for the prompt-month of delivery does not provide enough explanation of what is really going on with the fuel. For example, as a propane retailer you want to know, “What are the future winter prices doing?”
Over the course of the past few summers, we have all experienced times where the Mt. Belvieu summer propane price might be the same price as winter Mt. Belvieu propane. Other times, the summer Mt. Belvieu propane price is 3 to 5 cents per gallon (cpg) cheaper than winter Mt. Belvieu propane.
Time Spread
Why does summer propane sometimes trade at a “discount” to future prices? Why does “front-month” propane sometimes trade at a “premium” to future prices? What I have described here is a time spread.
A time spread is the difference between two months on a forward curve. The structure of that forward curve – the difference in the time spreads – reflects the supply and demand of the market.
Definition of Terms
- Forward Curve – a set of commodity prices at a specific location (Belvieu/Conway) at future specified contract months
- Time Spread – the difference between two months on a forward curve
- Contango / Carry – where the current/prompt month is selling for less than future months (weaker market)
- Backwardation – where the current/prompt month is selling at a premium in relation to future months (stronger market)
