Running Out of Gas?
When you take crude oil to the refinery and ‘crack’ it, you get two products: gasoline and ultra-low sulfur diesel fuel (ULSD). Therefore, it makes sense that these two energy products would have a strong correlation.
We can talk about the correlation coefficient or discuss fundamental links all day long, but I think there’s a much faster way to determine the correlation between markets. Simply overlay the price data of a few decades and see if there’s an apparent relationship. If the two markets typically run together, you’ve got yourself a good market pair for spread trading.
Now, there will likely be times where one market zigs and the other one zags. Or there may be times when a market makes a big move and the other makes an anemic move or does nothing at all. But those are usually where the good spread opportunities materialize. So it’s not how correlated the markets are all the time, but how correlated they are most of the time.
Having said all of that, take a peek at the last thirty years of monthly closing prices of RBOB and ULSD. You can see that the two markets are very correlated.
A Note on ULSD
In case you don’t already know, the ultra-low sulfur diesel fuel (ULSD) contract was previously the heating oil contract. The only difference between them is the amount of the sulfur content. Three years ago, the distillate fuel contract specs for sulfur content was lowered substantially from 2,000 PPM (sulfur content) to 15 PPM. The change was made in compliance with EPA rules.
For those of us who rely on price history and statistics to locate trade opportunities, this change has not mattered. The ULSD contract seems to follow the same seasonal patterns as heating oil and the inter-market relationships continue to function the same way.
Given the strong correlation between the gasoline and the ultra-low sulfur diesel fuel, one may wonder if there’s much of an opportunity for a spread trade. After all, it doesn’t appear that there’s a divergence between the two markets. They seem to be trending closely together.
However, once you plot the difference between the two markets -aka the spread– you will see that there is quite a bit of movement and, therefore, trading opportunities.
Looking at three decades of price history, you can see that the spread has been unsustainable whenever the nearest-futures RBOB has reached a price premium of 20 cents or more over the nearest-futures ULSD. This year is only the eighth time it has happened in the last thirty years.
The duration of the premium is getting long in the tooth as well. On a monthly closing basis, the nearest-futures RBOB has closed with a premium of 20 cents or more for three consecutive months. This matches the record three-month durations of March-May 2004, May-July 2006, and April-June 2007.
If it weren’t for the April 2006 close of 18.46 cents, the spread would have closed above 20 cents for five months in a row. Nonetheless, the three month duration is still historically stretched. And in a couple more weeks, the current duration could be stretched to four consecutive months.
The Ratio Confirmation
Coming from a slightly different angle, the ratio between gasoline and ultra-low sulfur diesel fuel also indicates that the RBOB is getting expensive.
In March the nearest-futures gasoline/ULSD ratio closed at 1.22:1 on the monthly timeframe. In the last thirty years, there were thirteen other times when the ratio made it to 1.22:1 or higher (on a monthly closing-basis). Even then, it proved to be temporary. The longest duration that the ratio was able to stay at 1.22:1 or higher was four consecutive months. It eventually turned over and dropped swiftly.
As we just pointed out, right now is only the eighth year in the last thirty that the RBOB gasoline/ULSD spread has reached 20 cents or higher. Interestingly, The prior seven occurrences all peak around this time of year.
Just one of the tops occurred in June and the other six tops were established in April or May. This implies that the short sellers should have the wind to their backs now.
Daily Spread Pattern
For trading purposes, we’re going to focus on the August spread. This gives us two and a half months until we’d have to worry about rollovers.
The August gasoline/ULSD spread may have established a double top-type pattern between the January 20th contract high of 24.52 cents (premium RBOB) and the slightly lower March 29th high of 23.87 cents. It would take a break below the February 8th low of 6.67 cents to confirm it, but we’d rather be short long before that happens.
Furthermore, the spread made a clean break below technical support at the rising 100-day Moving Average this month. This is a significant event. Previous drops to either side of the 100-day MA in May 2015, late August/early September, and once again in mid-February were followed by quick recoveries. This time, it appears to have broken through. That’s bearish, folks.
Picking My Spot
Now that the 100-day MA has been broken, it goes from being a support line to a resistance line. So I would normally look to sell the first bounce into the 100-day MA.
However, with US driving season set to kick off during the Memorial Day weekend in just two weeks, there is a chance that the bounce could be significant and initially overshoot the 100-day MA (currently around +17 cents). So I initially want to lead the target and shoot for a higher resistance level.
A Fibonacci .618 retracement of the current decline off the March high would send the spread up near +20 cents again. This is coincident with the late April bounce high. Therefore, a rally into this area could be a nice selling opportunity.
If we get lucky and short the rally, we will certainly look for a setup to add to the position. A bearish trend reversal could invert the spread and give the ULSD market the price premium. A break of the February correction low should confirm that this energy spread is going to tank, so we want to take full advantage of that. So get ready to step on the gas!
The blog will work a hypothetical order to sell one 42,000 gallon August RBOB gasoline contract and simultaneously buy one 42,000 gallon August ULSD (heating oil) contract on a rally to +19.75 cents (premium RBOB). If filled, risk a two-consecutive day close above +24.75 cents.