Hedging 401: Location and Timing Spreads
Spreads “Speak” Volumes about Commodities
Financial spreads could be called “signs of the times” for almost any traded commodity or market. The idea is that spreads can tell us a lot about what IS happening as well as what COULD happen with a commodity or in a market. If you understand how to “hear” them, spreads can speak volumes about perceptions or reality within the trading community.
We began this Hedging 401 series with a description of a spread and then went on to define two prominent spread relationships: contango and backwardation. In this third installment, we would like to build on those definitions and describe how spreads can be interpreted for almost any traded commodity when dealing with location, timing, or even other similar commodities.
Location, location . . . locational spreads
After almost thirty years in the energy industry, one of the most frequent questions I get from friends and family is, “Why does gasoline cost more in this city versus that city?” Instead of boring them with details about refinery runs, state gasoline requirements, and pipeline availability, I usually say, “It’s all about location.”
For example, let’s say my friend lives in the middle of Kansas and gasoline has to be trucked into their town from a storage terminal three hours away. That gasoline will have an inherently higher cost than it would in a town only thirty minutes from a storage terminal in the same state.
A locational spread refers to the pricing difference between two different physical locations.
Trading firms follow locational spreads because they help identify challenges or opportunities in the market. Looking back at our gasoline example, if there is a more cost-effective gasoline supply source than the normal location three hours away, a trading firm has the ability to capture extra margin. My friend’s town might still pay the same price for their gasoline, but someone in the supply chain has garnered more margin.
A locational spread refers to the pricing difference between two different physical locations.
Timing spreads within the trading community refer to the price difference between the delivery times for a given commodity.
In the propane sector, a July versus January timing spread would be called a summer/winter spread.
It’s all about . . . Timing Spreads
William Shakespeare could probably take credit for the origin of the phrase, “timing is everything“, but that truth predates the bard.
Timing spreads within the trading community refer to the price difference between the delivery times for a given commodity.
In the propane market, an example of this would be the price difference between propane delivered in July versus propane delivered in January. This type of timing spread may also have a specific industry name. For instance, in the propane sector, the July versus January timing spread would be a summer/winter spread because it highlights a prominent summer month and a prominent winter month.
Why are timing spreads, or more specifically, summer/winter spreads important? For markets that rely heavily on a particular fuel for heating (such as natural gas and propane), a summer/winter spread could indicate how the market views the demand for future heating fuel or the supply of that fuel.
Many market participants may say that middle of summer prices should be lower than winter prices. This is due to expectations of higher usage of the fuel to provide heat during a cold winter period. However, what does it mean when the timing spread does not show that picture?
Does it mean:
- That there could be a more prominent need in the middle of summer?
- That expectations for winter are forecasting warm weather?
- That other uses of the product are greater than using the product as a heating fuel?
- That product supply could be dwindling?
Carefully reviewing timing spreads for a specific commodity can lead to all these questions (and more!).
Conclusion
We are not trying to answer every possible question that could arise from a review of spreads with this series. Instead, we want to demonstrate how spreads help traders, and many other people, to effectively evaluate the market and make informed decisions about future price movements.
Be on the lookout for the fourth and final installment in the Hedging 401 series! We will take a look at what information can be learned from spreads between different commodities.
Hedging 401: Part Three
By JD Buss
