Futures spreads are another tool traders should be familiar with. In short, a spread will consist of being long one commodity and short another.
There are intra-commodity spreads, like being long May corn and short December corn, and there are inter-commodity spreads, like being long May wheat and short May corn.
Personally, I like spreads. At times, they can offer a little more staying power. That does not mean that spreads are less risky, but in my opinion, they can provide a trader with more room to manuever.
There is an excellent article about future spreads written by my colleague at Cannon Trading, which you can read here. There is also a great source, called MRCI. The team at MRCI produces many different reports about seasonal tendecies, among other financial concerns. One of their reports is the monthly spread idea report. This month, one spread in particular caught my eye. It is the long May unleaded gas and short May heating oil.
Below is some of the logic shared by MRCI for this trade, which I am sharing with you:
Some seasonal movements that seem driven by little apparent logic may actually be generated by fundamentals known best to those in a related commercial activity. Others, however, may be perfectly obvious upon careful consideration.
For example, consider gasoline and heating oil. We have many times discussed how seasonal patterns of consumption for these two primary petroleum products vary inversely. When consumption of heating oil is greatest during the cold of winter, consumption of gasoline is at it's lowest level, since driving conditions are worst. Conversely, when consumption of gasoline is greatest because driving conditions are best, school is out and families go on vacation, consumption of heating oil is least...because temperatures are highest.
But it is during periods of accumulation and liquidation when markets move most. Why? Because a primary function of markets is not so much to reflect, but rather to anticipate. Everybody knows when consumption is high -- which is why price is already high. Reward goes to those who take the risk of anticipating what the future will bring, rather than to those who know what everybody else knows.
Getting Ahead of Oil and Gas
Thus it is that as winter draws to a close, gasoline has usually outperformed heating oil. Distributors ever more aggressively liquidate their stocks of heating oil in order to avoid getting caught with too much inventory when consumption falls off a cliff. In contrast, the industry knows that, as temperatures warm, driving conditions improve. As they do, daily consumption of gasoline rises. But the industry also knows it must aggressively accumulate inventory of gasoline for the upcoming vacation and driving season, the traditional opening of which is Memorial Day weekend (last Monday in May). This combination of rising consumption and inventory accumulation conspires to accelerate demand for gasoline, usually driving price higher during the spring. In fact, MRCI has found that May gasoline has closed higher on about March 31 than on about January 27 for the last 16 years consecutively. It has also closed higher on about March 9 than on about February 1 in 15 of the last 16 years.
When combined with declining consumption of heating oil and inventory liquidation, gasoline has regularly outperformed heating oil in late winter. For example, the Long May Gasoline/Short May Heating Oil spread has closed more favorably toward gasoline on about March 26 than on about February 23 in 25 of the last 29 years, and in 17 of the last 18. In only five of these years would any daily closing drawdown have exceeded $2.92 cents/gallon. (Each 1.00 cent/gallon is worth $420.)
From last May through December, the spread traded at discounts in a range mostly between -5.00 and -10.00 cents/gallon. But then in January, it followed its normal pattern, breaking out of that range as gasoline began seriously outperforming heating oil. By the end of the month, it had converted a discount to a premium, as it reached +3.49. It has since been retesting even money.
Has it now exhausted its potential? One might think not. Although an unexpected, extreme cold snap might force this spread back to a modest discount, long-term charts show that last year's spread traded a premium of +11.26 -- and that was the lowest extreme premium such spreads have reached in each of the last 14 years prior to their respective expiries. Seasonal logic might suggest this spread has still higher levels to explore before May.
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