Intra-commodity spreads

A Commodity often trades at different prices for different times

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An intra-commodity spread is the purchase of a futures contract and the simultaneous sale of another futures contract for a different month in the same commodity on the same futures exchange. Intra-commodity spreads are calendar or time spreads.

Commodity futures exchanges often offer futures contracts in each commodity for many individual months that span from nearby to the distant future. The nearby futures contract is the closest to the current date.

Generally speaking, the majority of volume and open interest occurs in nearby futures contracts. This is because speculators and traders generally use nearby futures contracts for positional activity. The relationship between one delivery month and another is the term structure of a market. This term structure often provides clues as to the fundamental supply and demand status of a market.

When nearby prices are higher than deferred prices a market is generally tight or in deficit. Traders call this condition of term structure a backwardation. When nearby prices are lower than deferred prices a market is generally in equilibrium (supply and demand is in balance) or a surplus or glut exists. Traders call this condition of term structure a contango.

Intra-commodity spreads are often the position of choice for professional traders. Market participants use these spreads to take advantage of commodities that swing from backwardation to contango and back again.

  These spreads are not only trading tools but they often provide excellent clues as to the future price direction of a market. Let us consider an example.

In June 2014, the price of nearby NYMEX active month crude oil stood at over $107 per barrel. At that time, the differential between NYMEX crude oil for delivery in February 2015 and NYMEX crude oil for delivery in February 2016 was an $8 backwardation- the nearby crude oil futures contract traded at a higher price than the deferred contract.

This differential, or the term structure of NYMEX crude oil futures, shifted in the months that followed June 2014. By July, the backwardation moved to under $6, by August it slipped to under $4. In late October, the two contracts traded at the same price. All the while, the price of crude oil moved lower- the term structure of the market was moving from backwardation to contango indicating a market moving from deficit to oversupply. By January 2015, the differential between February 2015 and February 2016 crude oil had moved to a contango of over $8 and the price of nearby active month NYMEX crude oil was trading below $50. As the chart illustrates, this was a dramatic move in term structure. The February 2015 versus February 2016 intra-commodity NYMEX crude oil spread moved over $16 in the span of 7 months. As you can see, intra-commodity spreads can be extremely volatile. They also offer insight into a market that is moving from deficit into surplus.

While this example deals with the crude oil market, intra-commodity spreads trade in all futures markets. Generally speaking, in financial markets and those commodities that are more sensitive to interest rates, intra-commodity spreads are less volatile than in other commodity markets.

For example, intra-commodity spreads in gold tend to be less volatile than in other commodities as gold is highly sensitive to interest rates. On the other hand, in futures markets that represent commodities that are highly sensitive to weather or changes in supply and demand like agricultural markets, intra-commodity spreads are often more volatile than outright nearby prices themselves. This is because supply or demand shifts can occur quickly and shift markets from surplus to deficit and back. This is why professional traders often use these spreads to position in markets.

As a nearby futures contract approaches delivery, speculators and investors who do not wish to make or take delivery will often roll their position to the new active month in order to stay long or short a particular market.

This roll involves closing the nearby position and moving it to the next futures contract month. The roll is an intra-commodity spread.

The term structure of a commodities market is not only a trading tool but also an indicator of fundamental strength or weakness. It makes sense to monitor intra-commodity spreads when trading or investing in commodity futures markets.