Energy trading question: spread trades (spark spread)
Hey guys,
I'm reading energy trading & Investing by Edwards and he briefly discusses some spread trades in the second chapter and I am confused about his definition of a spark spread, amongst other things. Edwards says that spark spreads are typically created by taking a short position in electrical power and a long position in natural gas however he doesn't elaborate on the trading relationship between them, or how they serve as a hedge. He does mention, however, that electricity and natural gas prices are highly correlated so I thought that perhaps this works because the gain in the long natty position would offset the loss in the short electricity position - in times of rising prices. Is this right or is there something else to it?
Thanks heaps!
The Spark Spread is the difference between the market value of electricity and the cost of production. A utility's risks are that Natural Gas (which is used to power generators that generate electricity) will rise in price and increase their costs or that electricity (what they sell) will fall in value. The Spark Spread allows the power utility to hedge their risk and lock in their margin.
There is the same thing in oil only they call it "cracks" and it is the difference between a finished product (Naptha, gasoline, Jet fuel, Kerosene, ect) and crude.
Of course, speculators are also active in the market and betting on if the spread will widen or tighten.
^^Very good answer. Well done.
To add. Power is traded on a curve, what we call the supply curve. Your cheapest forms of power are Hydro, Nuclear, Coal, Wind etc. Therefore Natural Gas/Heating Oil only kicks in at the end of curve as we reach the peak periods of energy usage based on demand.
The Peak hours are the most important for the utility since that is when the marginal unit of energy can skyrocket since the utility needs to meet demands and can't just shut off a whole bunch of homes. A power plant that burns natural gas does so at a heat rate, meaning the amount of natural gas needed for 1 mwh of power. So when we hit the upper ehelon of peak demand, the natural gas power plant needs to run, therefore as the price of power rises the price of natural gas in appropriate heat rate will rise as well.
I am somewhat sleepy, hopefully some of that made sense.
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