Generating additional profit margin for wholesale energy sellers generally requires a willingness to take on added speculative risk. Understanding systematic basis movement tendencies enables sellers to increase margins without greatly increasing risk. This is the essence of arbitrage hedging.
The tendency of basis to narrow over time at a predictable rate in a contango market, is a low risk profit opportunity. In a full carrying charge market, basis will narrow over time at a rate approximately equal to storage costs per unit of time. To profit from this narrowing basis movement simply buy the less expensive cash commodity product and sell the corresponding futures contract. As the basis continues to narrow the loss on the cash position will be offset by the greater gain on the futures contract.
The key to making arbitrage hedging a consistent winner is understanding the type of market the particular energy commodity you are selling is currently trading. Should the outlying futures contracts be trading below current spot prices, the above strategy would result in a loss. In this scenario of a backwardated market, basis movements are not systematically predictable.
There are very few low risk opportunities for energy wholesalers to add profit to each gallon sold. Taking advantage of systematically predictable basis movements through arbitrage hedging, is one strategy that every seller with storage capacity should be aggressively implementing.
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