Spark Spreads

Discussion in 'Commodity Futures' started by Ashap13311, Aug 5, 2009.

  1. Question from (obviously) someone who's not a trader:

    I understand the concept of the spark spread, like a power producer using it to lock in a margin.

    But I don't understand what it means to "quote" a spark spread, e.g., if a party is quoting bids and asks for a spark spread, what does that mean? Does it mean it just quotes prices at which it will buy natural gas and sell electricity?

    Very confused here, hoping someone can help out...
  2. The exchange spark spread is intended to simulate the profits from a power plant by shorting electric power and buying the fuel used for generation – fuel oil, natural gas, or coal. The ratio of the short to the long position is determined by the heat rate of the plant.

    For example:

    IF power sold for $31 per Mwh and the price of gas was $2.60 per MMBtu, then the profit from the position would be $31 -
    8*$2.60 = $10.20 per Mwh. There is, however, one small wrinkle to the problem. We cannot simply buy nine gas contracts to every electricity contact, since an electricity contract is 736 Mwh and gas contracts are in 10,000 MMBtus.

    Therefore, you have to determine a hedge ratio h, which represents the number of gas contracts relative to 1 electricity contract. This is quite easy to compute.

    For every 1 electricity contract, you would need to buy approximately 0.6 gas contracts. Since you can’t buy fractions of a contract, you need to rewrite as a fraction with lowest common denominator. Thus you would buy 3 gas contracts for every 5 electricity contracts.

    spark spreads must now be bought on Nymex over the counter (ICE too) as standart swap contract.

    This will help.
  3. I understand that part.

    I guess my question concerns the mechanics of an OTC spark spread trade.

    Does a party quote a spread and then negotiate prices for the two legs (gas and power) of the spread? Like if they sell the spread to another party, would the legs of the spread be two separate transactions with that party -- a sale of gas and a purchase of power? I just don't understand how, mechanically, these spreads are quoted OTC.
  4. When the brokers quote heat rates, both parties will agree on the legs, if not, no deal.