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Different opportunities within the same commodity…
In a previous article, we examined the family relationship that different commodities can have with one and other. I explained that buying one commodity and selling a related commodity is known as an inter-commodity spread. These spreads can often be more volatile than the underlying individual commodities themselves and can give clues as to the future performance of one or more commodities. I pointed out the relationship between soybeans and corn and that historically soybeans were cheap relative to the corn price.
While an inter-commodity spread contains a long and short position of two commodities that are related as parents and children or cousins; an intra-commodity spread can best be described as a spread between siblings. An intra-commodity spread is a spread within the same commodity. And, an intra-commodity spread can give important clues as to the future price of a commodity.
In fact, I believe that an intra-commodity spread in natural gas may be giving a call to action in that commodity at this very moment! Let’s understand intra-commodity spreads before we get to the current situation in the natural gas market.
There are several different types of intra-commodity spreads:
- Location Spread- the same commodity that is traded in different delivery locations
- Quality Spread- the same commodity might have different standards and grades measuring value and quality
- Time Spread- different prices for different months
As with inter-commodity spreads an intra-commodity spread can also be very volatile. Let’s look at some examples:
The Crude Oil market can offer many intra-commodity opportunities:
Crude oil is traded all around the world but in the world of traded futures, the two biggest markets for crude oil are the NYMEX based WTI crude oil futures and the Brent North Sea crude oil futures. Both are low sulfur crudes but WTI is sweeter and better for refining into gasoline while Brent is better for refining into heating oil and diesel fuel. The intra-commodity spread for WTI versus Brent crude is both a location spread and a quality spread. Location in that the North Sea is in Europe and the WTI contract is for delivery in Oklahoma. Quality in that WTI is slightly sweeter crude or a different grade from the Brent.
Since the start of 2010 the price for Brent North Sea crude oil futures has appreciated dramatically relative to the price of the WTI futures:
As a matter of fact the Brent crude has moved from flat with WTI crude to a premium of $22 per barrel. This is a recent development as a longer term chart will show:
There are many reasons for the huge premium of Brent over WTI.
First, there is a lot of crude oil and a lack of storage space in Cushing, Oklahoma; the delivery point for WTI. Secondly, the Brent crude is scarce today because oil platforms in the North Sea need upgrading and the North Sea oil fields are declining. Additionally, Brent crude is subject to a bigger risk premium as its price is affected by events in Russia, the Middle East and Africa.
In any case, the intra-commodity spread of WTI versus Brent crude oil has moved big this year and seems to be steady at over $20 per barrel! On a percentage basis the move in the spread dwarfed the move in the outright WTI or Brent oil price.
There is another intra-commodity spread that has been moving that I would like to call your attention to – the spread between December 2011 and December 2012 NYMEX WTI crude oil. This is simply a time spread for one particular month crude oil versus another:
Notice that since April of this year this “time” spread has moved from -$4.00 to +$4.00 per barrel. The market in this spread moved from a $4 backwardation (backwardation is where the nearby is higher than the deferred contract) to a $4 contango (contango is where the nearby is lower than the deferred contract). Based on a crude oil price of $90 per barrel that is a 9% move in this spread itself! The upward trajectory in the December ’11-Decmeber ’12 NYMEX crude oil spread tells me that the market simply expects higher prices for crude oil in the future. Market participants (and in this case consumers) are willing to pay higher prices for future oil than they are for oil today reflecting the longer term bullish nature of the oil market. The intra-commodity spread is telling me that the market expects crude oil prices to move higher over the next 18 months. Intra-commodity spreads—what an amazing tool!
The Wheat market trades in different locations:
The wheat market has been in bullish mode since 2008. A ban on Russian exports last year (which has recently been lifted), a drought in Australia and poor yield on US wheat crops propelled the wheat market from $4 a bushel in 2007 to over $10 in 2008. Wheat is currently trading in a range between $7 and $8 per bushel.
On the U.S. exchanges there are a number of wheat contracts that are traded. The most liquid and active contract is traded on the Chicago Board of Trade or CBOT wheat. Wheat traded in Kansas City is a better grade of wheat, that wheat is known as KBOT wheat. Over the past two years the premium of KBOT wheat over CBOT wheat has increased dramatically.
Let’s take a look at this intra-commodity spread on a monthly chart:
This is an example of an intra-commodity spread that is both a location and quality spread. The KBOT wheat has moved to a premium for a variety of reasons including the fact that the KBOT wheat carries a premium for the higher quality and that more consumers in the US use the KBOT wheat for pricing and delivery.
Natural Gas time spreads may be telling us something about the future:
Historically, the natural gas market is one of the most volatile commodities traded. As volatile as the outright price of natural gas can be, the month-to-month spreads and location spreads in the physical natural gas market can be even more volatile than the price of the active month contract! Just ask Brian Hunter (no relation to Trade Hunter!) the famed natural gas trader at Amaranth, the hedge fund that blew up in 2006.
Amaranth lost $6.5 billion on natural gas outright and on intra-commodity spread positions in that year. Mr. Hunter had a huge portfolio of physical location swaps and long positions in natural gas and Amaranth took a bath when those positions went the wrong way. Again, intra-commodity spreads can be very volatile!
Currently, the natural gas market is dead. The price has not moved much since it came down in 2008 from $13 per mmbtu. The price of natural gas is trading around the $4.00 level, which is very low given the high price of other commodities and the secular rally in the commodity sector in general.
Let’s take a look at the December 2011-December 2012 futures spread in the natural gas market today:
This intra-commodity spread is telling us something about the future expectations of price in the natural gas market. As you can see, the spread between these two futures contracts has been making higher lows and higher highs since the beginning of 2011. There is a clear uptrend in the spread. This tells me that the market is expecting higher natural gas prices in the future.
Based on the low price level of this commodity and the movement in the spreads, I believe that natural gas prices are more likely to trade higher in the future! As I wrote in the beginning of this piece, I believe that this intra-commodity spread in natural gas is a call to action — it is telling us to buy natural gas because the price is going higher over the next 18 months!
Intra-commodity spreads can tell us a lot about the future direction of a market. Whether it is location differentials, quality differentials or times differentials. The information provided by an analysis of intra-commodity spreads in different commodity markets is an invaluable tool when making price predictions. As any good detective will tell you, the more clues you have the better your chances of success!
Happy trade hunting….
Other Posts from the Author
- How to Profit from the Changing Chinese Diet - May 15th, 2012
- Emerging Market Demands Mean Volatile Food Prices Are Here to Stay - May 10th, 2012
- Who’s an Uncivilized Jerk? - May 7th, 2012
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