Spreads
The risks posed by price volatility are not limited to movements in individual commodities. Because business relationships do not always match market dynamics, companies often face risks associated with the relative price differences between different but related commodities or products. Commodity prices can react very differently due to the location of their delivery, the type of commodity, or the time that delivery is scheduled. Spreads lock in the relative pricing between two different commodities, thereby eliminating this risk. Noted below are some products commonly used to hedge these risks.
Basis Spreads (location)
Due to factors such as origin, transportation, and market liquidity, similar commodities trade at different prices in different geographic regions. Doing business across these regions means that what you pay for a commodity in one location may influence what you need to sell it for in another location. The wrong movement of either one of these prices can cause significant financial losses.
For instance, a natural gas producer financially hedges its product with NYMEX Henry Hub futures, but its physical customer pays based on the Permian Basin Index price. If Permian prices were to drop more than Henry Hub prices, over time the company's margins would be at risk. To avoid this, basis spreads can lock the price of Permian Basin gas relative to movements in Henry Hub prices, thereby ensuring that the producer's hedging strategy is failsafe.
Cross Commodity Spreads (commodity)
Different businesses rely on different and multiple commodities as either inputs or outputs. Cross commodity spreads guarantee the relative price between different commodities on a BTU or equivalent basis. This may be important to lock in relative input and output prices, to fix a gross margin or to maintain competitive fuel advantage by fixing your fuel costs relative to the movements in another commodity (e.g., natural gas relative to coal costs in a predominantly coal-driven power market).
An example is an independent power producer (IPP) who relies on the price of natural gas as fuel cost and the price of electricity as sales revenue. A cross commodity spread can allow the IPP to lock in these relative prices and thus a gross margin for its business. The relationship of natural gas to power within a region is often referred to as the spark spread.
Calendar Spreads (time)
Because the purchase of a commodity can occur months prior to its use, the price fluctuations during that time period can pose significant risk. Calendar spreads allow companies to lock in the relative value of purchasing a commodity in advance of a future use or resale date.