By Jason Pearce
A High Energy Seasonal Spread 
Energies are an important sector of the commodity markets as they have one of the most widely-felt impacts on the global economy. The price of crude oil is used as a bellwether of inflation. This is why you may see the price of oil quoted in many market news reports. Heck, even the non-traders among us notice how much gasoline prices can fluctuate throughout the week. Driving by the local gas stations every day can prompt plenty of comments at the water cooler later on at the office.
Interest rates, currency exchange rates, shipping costs, the economy, war, and politics can influence the price of crude oil. Just as importantly, the tail can wag the dog as crude oil prices can influence interest rates, currency exchange rates, shipping costs, the economy, war, and politics! This makes the energy markets important for hedging. It also means that energies offer great opportunities for speculation.
In addition to crude oil, one can also trade the crude oil products: the RBOB gasoline and the ultra-low sulfur diesel fuel (ULSD). Furthermore, you can trade the inter-market relationships between all three markets. Right now, there may be a trading opportunity shaping up between gas and ULSD.
Energy Product Price Correlation
Even though the usages are different, gasoline and ULSD are highly-correlated in respect to how their prices move. If you removed the labels from the price charts of gasoline and ULSD and superimposed one of them over the other, you’d be hard-pressed to pick out the differences. This makes them ideal for spread trading.
RBOB Gasoline ULSD overlay (nearest-futures) monthly
Just so you aren’t surprised, you may want to know that the ultra-low sulfur diesel fuel (ULSD) was previously a heating oil contract. However, the only different is the sulfur content. In compliance with changes in the EPA rules for distillate fuels, the contract specs were changed from 2,000 PPM (sulfur content) to a mere 15 PPM. This happened back in the spring of 2013.
As far as price behavior goes, it appears that nothing has changed. Many ‘old-timers’ still refer to ULSD as the heating oil market. That’s certainly good news for those trading on seasonal patterns and historic inter-market relationships.
It’s Time to Get Crackin’
This week is the start of a strong seasonal pattern for the spread between RBOB gasoline and ULSD (ultra-low sulfur diesel). Until early January, gas should be able to outperform the ULSD market.
Counter-intuitive…Or Is It?
Fundamentally, one would think that the price of heating oil –I mean, ULSD- would heat up as winter approaches because of the dropping temperatures. In addition, one might expect gasoline to stall out because driving should be on an overall decline (going to Grandma’s house on Thanksgiving is the big exception, of course). So shouldn’t we be buying the ULSD contract and shorting the gasoline?!
The fact of the matter is that everyone knows the seasonal expectations for demand. It ain’t rocket science. However, the job of the futures markets is to anticipate and price in the expectations for the future.
The refiners start cracking the crude and stockpiling heating oil long before the cold weather actually arrives. They continue to operate at capacity, which means they are not making as much gasoline. Therefore, the heating oil inventories are usually plentiful by the time winter actually gets here. Barring unusual weather extremes like a Polar vortex, the heating oil prices can then be on a downward slope once Christmas shopping season arrives since there is plenty of supply to meet the demand.
Historical Boundaries
If one were to look at the last thirty years of price history, it would appear that there’s no real trend in the ratio between RBOB gasoline and ULSD. Therefore, the prudent strategy would be to sell when the ratio is near the high end of the historical range and buy when the ratio is near the low end of the historical range.
RBOB Gasoline ULSD ratio (nearest-futures) weekly
On the low end, the gasoline/ULSD ratio becomes a candidate for purchase after it drops to 0.85:1 or lower. This has only happened about a dozen times (basis the nearest-futures) in the last three decades. Each occurrence was a temporary event. Therefore, you should look for a setup to get long when the spread is in the tank.
Current Technical pattern
The March 2016 gasoline/ULSD spread has been in an uptrend since just before Labor Day. As a matter of fact, one could even argue that the spread bottomed nearly a year ago. After a sizable correction during the whole month of August, the uptrend continued. The spread is still in a bull market.
March 2016 RBOB ULSD spread daily
At the end of October, the March 2016 gasoline/ULSD spread cleared resistance at the July price peak of -17.36 cents (premium ULSD). This was a bullish breakout. Now that it has been cleared, the July peak has become a price support level. A pullback to somewhere around the July top should be viewed as a buying opportunity.
The ratio looks bullish as well. First of all, there’s the double bottom that was established between the December 2014 and August 2015 lows just above 0.83:1. This set the foundation for a bull market.
March 2016 RBOB ULSD ratio daily
Secondly, although it has already risen from the August low, the current ratio of just under 0.89:1 is still historically cheap.
Be aware, however, that this observation is made on the nearest-futures price data. Because the seasonal patterns are partly baked into the price, you don’t always see the prices in the expiring contracts and the distant month deliveries converge. Notice that the April 2016 ratio is already priced at 1.03:1 because of the expectation that demand for gasoline is higher after the heating season ends in the March/April timeframe.
Jumpin’ Jack Flash
We know that right now is the time of year to get long the March 2016 gasoline/ULSD spread. This is a seasonal trade with a high hit rate. We also know that the technical structure of both the spread and the ratio is bullish. This reinforces the outlook for a higher price.
Given the fact that the spread is currently in a pullback from the recent new contract high, spread traders could have an opportunity to quickly add to a long position. The seasonal play calls for getting long on Tuesday. The setup for an ‘add-on’ position would be to buy another spread on a close above the November 9th contract high of -13.17 cents (premium ULSD). You could risk the ‘add-on’ position to a close below the November correction low that precedes the entry. This allows you to really step on the gas if you have a winning trade on your hands.
Just like the commodity itself, trading a gasoline or ULSD futures contract can be both risky and volatile. Handle with care. You should know your risk tolerance and determine your position size before you jump in…or else your account could be gone in a flash.
