ULSD/Crude Spread: Good Place For a Trend Change

A Matter of Semantics

I’ve been trading futures for twenty-five years now.  As on old guy, I still catch myself referring to one of the crude oil derivative contracts as heating oil.  But it’s not.

To comply with EPA rules, the specs for sulfur content on the heating oil contract was changed from 2,000 PPM (sulfur content) to 15 PPM.  Due to this significant modification, the contract was renamed the ultra-low sulfur diesel fuel (ULSD) contract.

Now when you ‘crack’ crude oil at the refinery, the two resulting products are gasoline and ultra-low sulfur diesel fuel (ULSD).  But forgive me if I still occasionally call it the heatin’ oil.  I’m an old trader.

Still Connected

Despite the change in the contract specs, ULSD and crude oil are still highly correlated.  So it’s still a viable candidate for spread trading.

ULSD Crude Oil overlay (nearest-futures 2013-2016) weekly

ULSD Crude Oil overlay (nearest-futures 2013-2016) weekly

As a matter of fact, look at the chart of weekly closing prices of ULSD and crude oil since the contract specs were changed in May of 2013.  Can you tell which market is which?  Didn’t think so.  The ULSD price plot is the red line and the crude oil price plot is the black line.  These two markets appear to stick together like Siamese twins.  As a spread trader, this is exactly what I like to see.

Historic Extremes

Using the heating oil data up until 2013 and the ULSD data since then, we can get over three decades of price history on the charts.  The heat/crude spread used to be expensive when it reached six dollars or higher.  That ceiling was permanently broken in 2005.

In 2004, we learned that crude oil’s previously unsustainable 1990 Gulf War high around $40-per-barrel could not only be surpassed, but in a few years consumers would wish the market could someday come back down to forty dollars!

By 2005, the heat/crude spread had blasted its way to new record highs as well.  The spread never made it back down to the six dollar area until the 2008 financial crisis caused a collapse in energy prices.  Even then, the spread oscillated around six bucks for several months in 2009 and took off on a run for record highs again two years later.

ULSD Crude Oil spread (nearest-futures) weekly

ULSD Crude Oil spread (nearest-futures) weekly

The heat/crude spread reached a crescendo at the October 2012 record high of $43.83.  After converting to the ULSD/crude spread in May of 2013, the spread has made runs to $35.13 in 2014 and $37.89 in 2015.  Despite the recent historic bear market in energies, the ULSD/crude spread has still never touched six dollars yet.

After walking through this history, this spread doesn’t seem very mean-reverting.  So what’s a trader to do?

I think there are two things we can do.  First, we should look at the ratio between ULSD and crude to normalize things.  This will compensate for the spread widening during the period of record high prices and tell us if the relationship between the two markets still shows mean-reverting tendencies.

Second, trade the price action.  Even if the ULSD/crude spread is not as mean-reverting as we might hope, the price action is still what traders should follow.  As long as we are following the trend, the “path or righteousness”, the path of least resistance, etc., we are on the right side of the market.  And if the trend lines up with the direction of historical mean reversion, then that’s just all the better!

Drum Roll…

Good news, folks!  The ratio between ULSD and crude oil does indeed show that the relationship is still very mean-reverting.  As was the case with the heat/crude ratio, the ULSD/crude ratio indicates that things are both expensive and temporary when the ratio exceeds 1.45:1.

ULSD Crude Oil ratio (nearest-futures) weekly

ULSD Crude Oil ratio (nearest-futures) weekly

When the heat/crude ratio reached 1.45:1 or higher in the past, it was only a matter of time until it dropped back down to 1.1:1 or lower.  Now that we’re dealing with the ULSD/crude ratio over the last three years instead, it appears that the upside deviations are followed by declines to either side of 1.2:1 instead of 1.1:1 like the heat/crude did.  This slightly higher downside destination likely just coincides with the change in contact specs.

Daily Pattern

The IMC blog is tracking the December ULSD/crude spread for a trading opportunity.  Now, the ratio is currently around 1.31:1.  Therefore, it is not at an historic extreme of any sort.  The ratio for the December 2016 contracts hasn’t been anywhere close to expensive since it reached 1.43:1 eleven months ago.

However, the spread is worth taking a look at.  First of all, the December ULSD/crude spread rallied as much as $5.90 from the January low.  It just recently closed just above the ever-popular 200-day Moving Average for a few days. Then it lost the upside momentum and started backing off.

This is somewhat similar to what happened last year.  First, the spread rallied as much as $5.81 from the January low.  In May it closed just above the 200-day Moving Average for a few days. Then it lost the upside momentum and started backing off.

Last year, the failure to make it clearly past the 200-day MA was followed by a multi-month decline of over fifteen dollars ($15,000) per spread.  This time, we’re starting from a lower price point.  But you can’t rule out a return to the January low or even another bear market leg down.

December ULSD Crude Oil spread daily (200-day MA)

December ULSD Crude Oil spread daily (200-day MA)

In addition, the multi-month high that the spread reached in early July happens to be just a dime past the Fibonacci .382 retracement of the entire decline from the 2015 high to the current 2016 low.

Over the last couple of months, the December ULSD/crude spread has been supported by the 100-day Moving Average.  The spread first cleared this technical barrier in mid-April.  A sharp pullback in early May caused a closed below the 100-day MA, but it was a one-day event.  The spread snapped right back and made its way to new multi-month highs where it finally reached the 200-day MA.

Daily Pattern

That brings us to what’s going on now.  From the July 11th high -where the spread tangled with the 200-day MA and the Fibonacci .382 resistance line- the spread sold off for five consecutive days and closed at the lowest price in a month.

The rally on Monday and Tuesday then took it back up to just three ticks shy of the Fibonacci .618 retracement of last week’s sell-off.

December ULSD Crude Oil spread daily (100-day MA)

December ULSD Crude Oil spread daily (100-day MA)

The July 18th pullback low at $14.01 and the rising 100-day MA (currently around $13.82) set near-term price support.  A break below this level could indicate that the early July test of resistance was the end of the multi-month run and that the recent bounce to a Fib retracement was a failed recovery.  If so, it would be a good technical reason to short the December ULSD/crude spread.

Trade Strategy:

The blog will work a hypothetical order to sell one 42,000 gallon December ULSD contract and simultaneously buy one 1,000 barrel December crude oil contract on a close below the 100-day MA (currently around $13.82).  If filled, risk a two-consecutive day close 50 cents above the highest close after July 18th (currently at $14.86).

 

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