Spread Risk & Spread Cards
We have previously discussed how companies manage their outright pricing risk through the careful management of hedge cards. These daily reports are a vital part of ensuring that companies remain within their agreed-upon risk tolerances that are impacted by their changing physical tonnages and price fixings made with counterparties. However, commodity companies also face another major risk that if not managed correctly, can easily negate the profits generated by their physical trading activity. I am talking about spread risk.
A company that executes futures trades to hedge its price exposure is at the same time creating another potential risk. When a futures trade is executed it will have a specific settlement date. In the metals industry, the date a trade settles is known as the prompt date. When the prompt dates of a company’s futures short positions do not exactly align with its futures long positions, there is a requirement to adjust these positions so that they do not become physical obligations - to either deliver metal to the exchange (if they are short futures) or receive metal from the exchange (if they are long futures). The act of moving a futures contract from one prompt date to another is known as a carry trade (or spread trade) and we have covered these carry trades in a prior article. But we have not looked at how companies can manage these known risks well in advance of settlement dates - they do this with a spread card.
Hedge cards that are used to manage outright price exposure only contain physical contracts that have been priced (and therefore should have a corresponding futures position). Spread cards on the other hand are used as a planning tool that make assumptions based on the dates unpriced contracts will eventually price. Because of this, they will contain all of the following:
Physical purchases that have been contracted but have not yet been priced,
Physical sales that have been contracted but have not yet been priced, and
Existing net futures positions for each monthly prompt date, for both current and future months.
By combining all their physical positions, both already priced (their net futures position) and unpriced, companies will be able to view their spread exposure in every month in which they have a position. This exposure will tell them whether they can expect to be net short or long futures and in what months, hence whether they have a borrowing requirement or a lending requirement. These positions and the resulting carry trades that companies make will have a P&L impact based on the forward curve each day. Companies use their spread cards to inform both their physical trading and carry trading decisions. That could be borrowing well in advance of pricing a physical purchase (sometimes known as a pre-borrow) to capture a contango, or avoid a backwardation. It could be seeing an opportunity to lend into a backwardation. A spread card could prompt a trader to ask a counterparty to price a contract early or late. There are countless opportunities that properly managing a spread card can prompt, but these opportunities to create profits, or save losses, can only be achieved if the correct procedures are in place and all employees involved in the process are fully aware of the impacts of their decisions.
Simple Spread Card Aluminum Dec 31st
As you can see from the table, as of December 31, the company holds a net futures position of short 500mt in January. This would suggest it is holding 500mt of priced stock going into the end of the year. It has a total of 800mt physical purchases and 300mt physical sales pricing in each month between January and May. Based on its existing physical purchases and sales, it is getting shorter futures at a rate of 500mt per month, during this time. If the company’s physical trading position doesn’t change between December 31 and January 31, it will have to borrow 1,000mt or 40 lots of aluminum out of January. In this example, let’s say the company borrowed those 40 lots from January to February. On January 31, its new spread card would look as it does in the below table.
Simple Spread Card Aluminum Jan 31st
The company knows that it still has a borrowing requirement out of February, and that it is still getting shorter at a rate of 500mt per month March-May. They could either borrow additional positions to move their shorts further down the curve, or they could make physical sales that when hedged (buying futures) would reduce their net short positions.
Suppose a company neglects to run a daily spread card and simply leaves these decisions until the last possible minute to adjust. In that case, they leave themselves fully exposed to the cost (or gain) of moving those positions on that day’s market rate. Given how sporadic and volatile metal spreads can be, and that there is no limit on how large a backwardation can be, the cost of not properly managing spreads can be disastrous to profits.
As an example of this, take a look at the LME forward curve for copper on October 4th, 2021. As you can see, while it is in a backwardation, it is relatively shallow, and while nobody enjoys borrowing through a $10/mt/month backwardation, it wouldn’t be disastrous.
LME Copper forward curve October 4th, 2021
Just two weeks later, on October 18th, 2021, the forward curve for LME copper had changed dramatically:
LME Copper forward curve October 18th, 2021
The cash to 3’s trading period was now printing a backwardation of over $1000/mt! If you had been short copper futures out of cash and had no other option but to borrow through this backwardation, every 40 lots you borrowed would have cost over $1,000,000!
Given that trading firms are often long physical/short futures, you can see how quickly profits can be jeopardized when positions are not properly managed. Spread cards give companies key insights into their trading positions and how they can effectively manage spread risk, creating additional value.
