What Is a Commodity-Product Spread?
The commodity-product spread is the difference between the price of a raw material commodity and the price of a finished product created from that commodity. The commodity-product spread forms the basis of some favorite trades in the futures market.
To trade on the spread, an investor typically combines a long position in raw materials with a short position in a finished product related to the raw material.
- A commodity-product spread is the price difference between a raw material commodity and the price of a finished product made from that commodity.
- Traders in the futures market can use the commodity-product spread as the basis for different trading strategies.
- Typically, traders will create the spread by selling futures in the raw commodity while simultaneously buying futures in the finished product made from the commodity.
- Alternatively, traders can take the opposite side and purchase raw commodity futures while selling finished futures.
- Three types of commodity-product spread strategies are the crack spread, the crush spread, and the spark spread.
Understanding a Commodity-Product Spread
Commodity-product spreads are a type of exotic option. The trader will sell futures in the raw commodity and at the same time buy futures in the finished product made from that commodity. Spread traders may also take the opposite side and purchase raw futures as they sell finished futures. These types of spreads are frequently seen in the oil and agriculture industries.
While exotic options can help offset risk in a portfolio, some exotic options have increased costs because of their added features. Additionally, the price moves for exotics can be much different than traditional options.
Types of Commodity-Product Spreads
The Crack Spread
The crack spread is the contrast between a barrel of crude oil and the petroleum products extracted from it. Cracking is an industry term that refers to the process refiners use for splitting apart crude oil into finished products. This includes gases like propane, gasoline, heating fuel, light distillates, intermediate distillates, and heavy distillates.
The Crush Spread
A crush spread is used to hedge the margin between soybean futures and soybean oil and meal futures. With this strategy, a trader takes a long position on soybean futures and a short position on soybean oil and meal futures. The trader may also take the opposite side of this options spread.
The Spark Spread
The spark spread uses natural gas as the raw material component and electricity as the finished product. Spark spread refers to a calculation used by utility companies to estimate the profitability of natural gas-fired electric generators. As a trading strategy, investors can use over-the-counter trading in electricity contracts to profit from changes in the spark spread. For coal, the difference is called the dark spread.
In all cases, taking a long position in the raw material against a short position in the finished product yields a return that implies the profit margin of the entity doing the processing.
For corporations that produce finished goods, contracts based on the commodity-product spread act as a hedge against price volatility on both ends of the manufacturing cycle. This hedging helps to protect a firm’s profits from rising costs if raw material prices rise or if prices for finished goods fall.
Speculative Commodity-Product Spreads
Speculative trades based upon the commodity-product spread also exist. Speculators profit when the difference between the prices in the trade becomes larger. Note that a risky trade could also involve switching the long and short legs of the spread depending on which direction the trader expects a price differential to go.
A speculator looking at the oil and gas market would take a similar position if they believed crack spreads were likely to widen. Since the speculator has no actual commodities to buy or sell, the result of the trade would be pure profit or loss, depending on whether the spread widened or narrowed.
For example, suppose an oil refiner decides to hedge its profits against changes in gas prices. The refinery takes a short position in petroleum products and a long position in oil futures. This way, any loss in the refiner's margin from a fall in gasoline prices should be offset by a gain in the hedge position.
However, if the price of gasoline were to rise, the profitable refining margin would be offset by an unprofitable trade. This type of hedging activity locks in a certain level of profit by using changes in the spread to offset changes to the refiner's bottom line.