CRUDE OIL CALENDAR SPREADS

Transcription

1 Chapter 4 CRUDE OIL CALENDAR SPREADS Trading in Light Sweet Crude Oil (WTI) futures takes place in New York on the NYMEX Exchange. The contract size is 1000 barrels (42000 gallons), minimum price increment: $0.01 per barrel ($10.00 per contract), ticker: CL. More detailed specifications of this contract can be found in Appendix 1 of this book or on the website of the CME Group: According to the convention adopted by the CME, the purchase of a crude oil calendar spread would mean buying a nearby contract and selling a distant contract, whereas a spread sale would mean buying a distant month contract and selling a nearby one. In a spread chart, the x-axis represents the time scale, and the y-axis represents the value of the spread. To derive the spread value, the price of the distant contract is subtracted from the price of the near contract. I use esignal 10.6 software from esignal Ltd. ( to construct spread charts. Alternatively, spread charts can be quite easily constructed by using Microsoft EXCEL. Figure 4.1 shows a spread chart between August 2010 (CLQ0) 3

2 CHAPTER 4 Figure 4.1 CLQ0/CLX0 Spread Chart Created with esignal

3 CRUDE OIL CALENDAR SPREADS and November 2010 (CLX0) oil futures, created with esignal 0.6. Figure 4.2 also shows this spread, but created by means of Microsoft EXCEL : : : : : : : : : : : : : : : : : : : : : : : : : : : : :00-0,40-0,50-0,60-0,70-0,80-0,90-1,00-1,10-1,20-1,30-1,40-1,50-1,60-1,70-1,80-1,90-2,00-2,10-2,20-2,30-2,40-2,50-2,60-2,70-2,80-2,90-3, :00 Figure 4.2. CLQ0/CLX0 Spread Chart Created with Microsoft EXCEL If the market price structure is in contango, then the graph will lie on the negative side (see Figure 4.1). If the market is in backwardation, the graph will be positive. At first, this may seem unusual, but we should remember that contango describes a condition when the price of a remote contract is higher than the price of a nearby contract; therefore, the difference between them will be negative. On the other hand, a backwardation market has a price structure in which the price of a nearby contract is higher than the price of a distant contract. Thus, the difference between them will be positive. When buying and selling identical contracts, we do not run into the problem of weighting the position by size. As all crude oil contracts, both nearby and deferred ones, are 1000 barrels in size, the spread is considered to be weighted, and the investor who is buying or selling the spread does not have to think how to calculate the value of a one-tick movement of the spread. As one tick of a crude 5

4 CHAPTER 4 oil contract for 1000 barrels is equal to $10, a onetick movement of the spread will also be equal to $10. I can provide a simple example to illustrate this point. We will assume that the spread between May (CLК0) and June (CLМ0) futures was $-1.20 on March 20. After two weeks, the spread changed to $ Thus, the spread changed by 0.40 points, which is equivalent to $400. I have already mentioned that the exchanges margin requirements for spreads are significantly lower than those for simple outright futures positions. Each exchange publishes on its website the current levels of initial and maintenance margin requirements for all contracts traded on the exchange. As a rule, the exchanges provide detailed methodological descriptions of how to calculate margins for various types of spreads. We should not forget that margin requirements undergo periodic re-evaluation because, in many respects, they depend on volatility; for the same reason, margin requirements for spreads are significantly lower as spreads are less volatile in money terms than outright futures contracts. When I began writing this book, the initial margin for a futures oil contract on the NYMEX was equal to $5.063, whereas the maintenance margin was $ Thus, when opening a position for buying or selling a futures contract, the trader had to deposit a minimum amount of $ At the same time, if the trader buys or sells a spread, that is, opens buy and sell positions simultaneously, the exchange s computer automatically recognizes such a structure and blocks a much smaller amount in the trader s account. Instead of $ odd dollars which would have to be deposited for two contracts, total margin requirements will equal not more than $ I do not specify the precise amount of initial 6

5 CRUDE OIL CALENDAR SPREADS margin for spreads for one simple reason the actual amount is subject to change. In order to simplify the calculations, we can start with a straightforward rule the initial margin for an oil spread will be no more than 20% of the initial margin for two separate contracts. It should also be noted that changes in the initial margin for spreads may be more aggressive than for simple futures contracts. Moreover, the NYMEX raises margin requirements for spreads after the open outcry trading session. In general, I saw margin requirements for oil spreads change from $600 to $1500. So, how does a spread really work? With our structure, in which a spread purchase means buying a nearby contract and selling a distant contract, several scenarios of future developments are possible. When a spread is purchased: If the prices of the nearby and deferred contracts rise, but the price of the near contract rises faster than the price of the distant one, the spread will narrow, and the investor who bought such a spread will make a profit as his long position will increase in value faster than the short one. If the prices of the nearby and deferred contracts fall, but the price of the near contract falls faster than that of the distant contract, the spread will actually widen. The investor who bought such a spread will incur losses as the long position will lose in value faster than the short one. If the price of the nearby contract rises, but the price of the distant contract falls, which in our case will mean that the spread will narrow, the investor who bought such a spread will make a profit as both the long and short positions will yield profit simultaneously. 7

6 CHAPTER 4 If the price of the nearby contract falls, but the price of the distant contract rises, the spread will widen. Such a scenario would result in a loss to the investor who bought the spread. We have described four potential scenarios, where each scenario represents a possible outcome of profit or loss for the investor who bought the spread. Logic prompts us to say that the fore-mentioned scenarios will present inverse results if the spread is sold. Let us give some examples of profitable and losing spread trades for illustration purposes and describe the methodology for calculating the result. The chart below shows the spread between July (CLN0) and November (CLX0) oil futures (Figure 4.3). Let s assume that, on , the investor decides to buy this spread. The spread when the trade was opened was The investor decides to close the trade eight days later, on We ll mention in passing that closing a spread transaction is the same as closing a futures contract, i.e. this will actually mean making an offset transaction. In the case of a purchased spread, this will mean selling the nearby contract and purchasing the distant one. So, the spread reached during the elapsed period. Thus, the change in the spread amounted to 0.64, which means that the investor made a profit of $640. There is a very simple method for calculating profits and losses from investments in spread positions. The spread value at the moment the positions were opened and closed are calculated first. Then, the difference between the initial and final values of the spread is determined by subtracting the purchase value from the sale value. The calculated difference is then multiplied by the value of one tick. This is necessary for us in order to obtain a 8

7 CRUDE OIL CALENDAR SPREADS Figure 4.3 CLN0/CLX0 Spread Chart 9

8 CHAPTER 4 money measure of the change in the spread. Calculations for the fore-mentioned spread are shown in Table 4.1. CLN0 CLX0 CLN0-CLX Long 82,70 Long 84,10-1, Short 83,80 Short 84,56-0,76 Spread 0,64 US$ Spread $640,00 Table 4.1. Purchase of CLN0/CLX0 Spread We shall now cite an example of a spread sale. We will assume that, on , the investor decides to sell the spread between the December 2010 contract (CLZ0) and the December 2012 contract (CLZ2) (Figure 4.4) in the hope of seeing the spread widen. At the time the trade was placed, the spread was The investor decides to close the trade on The table below shows the result gained by the investor. CLZ0 CLZ2 CLZ0-CLZ Long 83,85 Long 86,72-2, Short 89,55 Short 93,25-3,70 Spread 0,83 US$ Spread $830,00 Table 4.2. Sale of CLZ0/CLZ2 Spread We see that the investor has earned $830. In order to provide a complete picture, we will give one more example of a scenario in which the outcome of developments turns out to be negative for the investor. Let s assume that, on , the investor decides to buy the spread between July (CLN0) and September (CLU0) oil futures (Figure 4.5), counting on the spread narrowing. 10

9 CRUDE OIL CALENDAR SPREADS Figure. 4.4 CLZ0/CLZ2 Spread Chart 11

10 CHAPTER 4 Figure. 4.5 CLN0/CLU0 Spread Chart 12

11 CRUDE OIL CALENDAR SPREADS The spread when the trade was opened was The investor decides to close the transaction on Table 4.3 shows the result obtained by the investor. CLN0 CLU0 CLN0-CLU Long 87,61 Long 88,81-1, Short 80,25 Short 83,69-3,44 Spread -2,44 US$ Spread -$2.240,00 Table 4.3. Purchase of CLN0/CLU0 Spread The table shows that the investor incurred a loss of $2,240 over the spread-holding period. Let s now enumerate the fundamental factors which, despite their conventional nature, have an effect on the value of spreads. These are the amount of oil inventories, increase in inventories over the previous reference period, change in inventories of gasoline and distillates, size of oil refiners margin, presence of a particular price trend on the oil market, and oil price volatility at the present moment. The main source of information used in analyses of energy futures is the Energy Information Administration (EIA) of the U.S. Department of Energy. The EIA publishes its data, analyses and reports on its official website: We will briefly consider how each factor can impact spread values. Amount of Oil Inventories According to the prevailing theory, an increase in oil inventories should widen the spreads. As we stated above, this does not always happen, however we should always consider this parameter very carefully. 13

12 CHAPTER 4 Increase in Inventories Over the Previous Reference Period A sharp increase in inventories gives a strong impetus to the widening of spreads. However, it should be noted that the longevity of this impetus is very doubtful. The effect of this announcement becomes dispersed within a period of 2 to 3 days if it is out of tune with the current trend towards narrowing of spreads. However, if spreads tend to widen in the market, then an announcement about a sharp increase in inventories will substantially strengthen the current trend. Change in Gasoline and Distillates Inventories Although these factors are indirect in nature, considerable fluctuations in any direction definitely impact the price of the nearby crude oil futures, and consequently, the spread value. For example, a sharp decrease in inventories of these products suggests a strong demand for derivative products of oil. This means that the nearby futures will strengthen in relation to the deferred one, and will possibly cause spreads to narrow. The opposite is also true a sharp increase in inventories implies weak consumption at the current moment, which may cause a certain stagnation in the consumption of crude oil and, thus, an increase in its inventories and a possible widening of spreads. Moreover, we can often observe a picture of crude oil and refined oil calendar spreads moving in the same direction. Size of Oil Refiners Margin I believe that this factor represents a very important indicator of future trends in the oil calendar spreads market. Significant increases in the margin over a relatively long period of time encourage oil refiners to increase 14

13 CRUDE OIL CALENDAR SPREADS their production, thus increasing the consumption of oil, which is one of the factors strengthening its price and causing spreads to narrow. If the oil refiners margin remains at a low level, we can expect to see growth in crude oil inventories and widening of spreads. Presence of a Particular Price Trend on the Oil Market If there is a rising trend for crude oil prices, we can expect spreads to narrow, as market players feel optimistic about prospects on the spot market, thereby increasing pressure on spreads. The opposite is also true falling oil prices make spreads widen, deepening the contango. This is due to the fact that oil traders would rather build up inventories in storage than sell on the spot market, planning to sell this oil at higher prices in the future. As mentioned earlier, in increase in inventories results in widening of spreads. Current Pace of Oil Price Changes I do not have enough proof to state that drastic changes in prices may have any great effect on spreads, except for my personal observations. However, we can be sure that sharp increases in oil prices have a narrowing effect on spreads, albeit for a very short time. When oil prices plummet, we will witness a contrary effect, that is, widening of spreads. It is very simple to find an explanation for this phenomenon. When there are sudden price variations, contracts with closest settlement dates are more sensitive to changes than deferred contracts as the futures market reacts to different kinds of events, first and foremost, through changes in prices of front month contracts. Distant contracts seem to be more inert and less volatile in this respect. For example, if there is a collapse of prices, nearby contracts will drop at a faster 15

14 CHAPTER 4 pace, which will result in widening of spreads, as we mentioned at the beginning of the chapter. 16