In Parts 1 and 2, we learned about commodities and derivative markets. Today, we’ll talk about a different kind of natural gas trading, and, as promised, we’ll talk about the crack spread and why you love it.

Hedging Further: OTC trading and commodity swaps

Another type of risk-hedging is achieved through OTC (over-the-counter) trading. These are trades that happen outside of any formal exchange, like NYSE, AMEX, etc. Futures contracts are carried out on formal exchanges. OTC trades, on the other hand, are individual contracts between two counterparties. A company might want to do this because they don’t meet exchange listing requirements for whatever reason—maybe they’re too small, or don’t really have their shit together yet.

For our purposes, we’ll look at a type of OTC trade called a commodity swap. Let’s say an airline knows it needs to buy 1 million barrels of jet fuel over the next year, but prices are crazy volatile for some reason. Maybe Iran is throwing a fit, or refineries are being all slow. The airline might enter into a commodity swap with an investment bank. Much like a futures contract, the airline agrees to buy x number of barrels of jet fuel at a fixed price over the next year, only this time, the airline buys month-to-month over a set period of time, like a series of futures contracts. This gets a little weird, but work with me.

The bank agrees, on its side, to pay the floating price (basically, the average of the spot prices over a given period of time, usually a month) for the fuel over that year. These are settled each month for an agreed-upon amount of time, so that’s why it’s sort of like a series of futures contracts. In our example, it’s each month for one year. In any given month, if the floating price goes over the agreed-upon fixed price, the bank sends the airline the difference that month. If the floating price is less than the fixed price that month, the airline sends the investment bank the difference.

 Why is anyone into this? THE CRACK SPREAD, for one:

You can easily see why the airline would be into this. The airline needs to make sure it has relatively fixed operating costs so it can plan for its output that year. Like how many cups of warm nuts they can give investment bankers in first class on their flights to Prague. Locking in a price for fuel for the year is a way to reduce its risk.

But why would the investment bank do this, especially in a volatile fuel market, where spot prices are clearly trashed and need to go home? Well, for one, the bank could do commodity swaps in other kinds of fuels to make up for any losses in jet fuel. This might be where the crack spread comes in. When crude oil is refined into other fuel products, the process is called cracking. The differential between the price of crude and the price of a refined fuel is the spread between the two prices as related to the current cost of cracking. An investment bank could be working a favorable crack spread to cover any losses in jet fuel by buying up futures in crude.

 …And that’s how it works:

In a manner of speaking, a bank can hedge its risk in the apple market by investing in oranges. Airlines can’t do that. All they care about is apples… i.e., jet fuel. This is where other kinds of OTC swaps come in, such as interest-rate swaps, credit default swaps, and currency swaps. These work much like commodity swaps, only with other kinds of bases. So, an investment bank could use different kinds of swaps in tandem to hedge its risk in other areas. In all above examples, I’ve talked about jet fuel, but replace “airline” with any industry that uses natural gas. There are other ways of arranging these instruments, but these are the most common.

Thank you for following me on this Journey of Discovery—let me know if you have any questions, or if there’s another topic you’d like to see!