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Commodity Spreads 4: Why the interdelivery spreads exist?

19 Dec 2017,

In the last part of the series about commodity spreads, we have defined what is the spread and what types of spreads we have. Today we will look closer to interdelivery spreads because this type of spreads is perfectly suited to my account size and my risk tolerance. We will get to the benefits of spreads next time, but today I want to explain the basic – why the spreads exist?

 

 

 

Repetition

We already know that interdelivery spread is simply the price difference between two contracts within one commodity. Let’s take an example. Corn delivered in March 2018 is traded at a price of 349 cents (name of the futures contract is ZCH18). Corn with a delivery date in July is traded at 365.5 cents (name of the futures contract is ZCN18). Spread, or the price difference between those two contracts is 16.5 cents (365.5 – 349 cents).

I think that is easy and understandable. But now the question is. How it is possible that spreads exist at all? Why do futures contracts for the same commodity have different prices? You often ask me about it in different conferences, webinars, or through messages. That is why we will explain this in more details today.

 

When buying Cocoa

Imagine that you are the Nestlé company, a manufacturer of chocolate and various sweets for the whole world. The main ingredient that you need to buy regularly to make chocolate is cocoa. Perhaps today you will realize that in three months you will need, say, 1000 tons of new cocoa. So, you have two options:

  • Buy cocoa right now and store it for three months.
  • Buy cocoa with a delivery in three months (cocoa will be stored for three months by the supplier).

 

Storage costs

In both cases, the same quantity appears – storage cost. In other words, if you store your cocoa, it will cost you something. To store a physical commodity, you must have some space with suitable conditions. But if you buy cocoa with a later delivery date, the supplier must stock the commodity for you. And, of course, he has some storage costs.

It does not matter whether cocoa is stored by you or someone else, storage costs are always present until cocoa is processed. These costs, of course, must also be reflected in the price of the commodity, in the futures price. It is, therefore, quite normal if futures contracts with a longer delivery are more costly. This normal state of the market is called contango, and its consequence is the existence of spreads.

In the following chart, you can see a term structure curve that displays the prices of all traded futures contracts. This means that it shows the distribution of commodity prices with different deliveries. To be more specific, the term structure shows us the current distribution of supply and demand over a period of time. It is a very useful thing, because, with its help, we can identify harvest times for grains, or heating season when it comes to energies, etc. I will come back to this later.

 

 

The chart shows the corn term structure on December 13th, 2017. It is visible that the market is in the normal state – in contango. Contract prices with more distant expirations are more expensive (horizontal axis – expiration, vertical axis – price). And as we have already said, one of the main reasons is storage costs.

Homework

For the next lesson, try to find on the term structure curve the spread that I have mentioned at the beginning of the article today. Mark it with an arrow on the chart, and then we’ll check the result together.

What’s next?

In addition to the contango, we also know another market state – backwardation, which is also called the inverse market. And we are going to tell something more about it next time. But that’s not all. We will also talk about how it is possible that spreads can be negative and how we can work with it 🙂

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