In Spring, Oil Traders’ Thoughts Turn To Spreads

March 11, 2010

What’s the real relationship between gasoline and heating oil—and how can investors use it to their advantage?
  • Consumption patterns: gas vs. heating oil
  • What’s inventory got to do with it?
  • Why a spread trade makes sense


As spring approaches, our thoughts turn to such warm weather pleasures as outdoor grilling and long drives into the countryside. Each expectation has its own set of investment implications. We last looked at protein's prospects in "Weekend Meat Musings"). So what about those bucolic sojourns?

We've been writing about fuel's fundamentals for some time now. As each weekly inventory report is issued by the U.S. Energy Information Administration, we recap the week's trading in crude oil and its most commonly traded refined products, gasoline and heating oil (see this week's analysis in "Oil Inventories Build For 7th Straight Week").

As you might imagine, the demand cycles for gasoline and heating oil are pretty much calendar opposites. Heating oil consumption typically peaks in the cold months of winter and early spring, while gasoline use reaches its zenith during the summer driving season. Given that, you'd think heating oil prices would be highest late in the year, and midyear spikes in gasoline costs would be common.

In reality, refined product prices are more highly correlated than you might have imagined. Since the 2005 introduction of reformulated gasoline blendstock for oxygenate blending—otherwise known as RBOB—gasoline and heating oil prices have tracked each other with an 81 percent correlation coefficient.


Gasoline Vs. Heating Oil Prices

Gasoline Vs. Heating Oil Prices


The reason for this is simple: It's uneconomic to refine crude oil without making both gasoline and heavier distillates. In summer, when demand for gasoline is at its peak, much of the petrol produced is marketed, while other distillates, including heating oil, are inventoried for later sale.

Inventory levels vary to a much greater degree than prices. On average, the correlation between distillate fuels stocks and total motor gasoline supplies is only 30 percent. Refiners can, to the degree their equipment allows, maximize their profits by adjusting their refining mixes. In the spring, they'll produce more high-margin gasoline from lighter grades of crude oil and bank heavier distillates. Later in the year, the process is reversed, as refining plants are retooled to produce proportionally more heating oil from heavier input grades.

As you can see from the chart above, there are times when the interplay of supply and demand produces outsized moves in product prices. Take a look at gasoline prices late in 2005. RBOB—trading at a discount of as much as 30 cents per gallon—rose to a 30-cent premium over heating oil by July 2006, a 60-cent boon for gasoline bulls. With a 42,000-gallon contract size, the potential gain on a single lot exceeded $25,000.

That scenario was repeated the following year, as gasoline traded up from a 17-cent discount to a 39-cent premium over seven months.    

You can more clearly see the widening and narrowing of the spread between gasoline and heating oil prices in the chart below:

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