- 15 Jul 2020
- By Paul Wightman and Cameron Liao
Prices in both the Soybean Oil - Palm Oil (BOPO) spread and the Palm Oil – Gasoil (POGO) spread exhibited high volatility as markets faced structural changes. The BOPO futures spread traded in a range -$10 to $150 per metric ton, while the POGO spread ranged from -$200 to $380 per metric ton in the past few years.
Price moves in these spreads are according to the demand/supply dynamics in the vegetable oil and energy oil markets. Price factors such as economic development, population growth, weather, government policy, and fluctuation in exchange rate may have more impact on one market than the other, resulting in price increase or decrease in the corresponding spread. Other factors like the ongoing U.S.-China trade friction and outbreak of coronavirus have also greatly impacted the prices.
This article examines the price relationship in the futures market between palm oil and soybean oil, as well as palm oil and gasoil. It also demonstrates how traders can use futures contracts at CME Group to trade the BOPO and BOGO inter-commodity spread.
Palm and soybean oils are the world’s largest vegetable oil markets, together accounting for more than 60% of global production. Both commodities are widely seen as interchangeable in the supply chain, often regarded as direct substitutes.
Typically, soybean oil trades at a premium to palm oil, while the prices tend to be correlated, moving in the same direction on the longer-term time horizon. However, the volatility in the spread can be significant, reflecting the different fundamentals of each market. Global soybean production is centred mostly in the U.S., Brazil, and Argentina, whilst the largest palm oil producers are Indonesia and Malaysia.
As the markets have evolved so have the trading tools to enable participants to manage price risk using futures. The most active futures spread is referred to as the Bean Oil/Palm Oil spread (“BOPO”). The soybean oil price is converted from US cents per pound to US dollars per metric ton for easier comparison1. Traders actively manage this price relationship in the futures markets.
Since 2015, BOPO spread had fluctuated but traded mostly above $50 per ton. In 2019, the spread narrowed significantly as palm oil price rallied on the back of slowing production and higher demand for biodiesel from government policy in the leading producing countries.
Chart 1 – Increased futures volatility in the BOPO spread
Source: CME Group
This example looks at trading the spread between Palm Oil and Soybean Oil. Prices of Palm Oil and Soybean Oil are correlated as they compete for share in the global vegetable oils market. Therefore, depending on price levels of each of the commodities, one would aim to lock in the price spread between the two in the futures markets. A trader may wish to buy or sell the spread, if the person believes that the spread will strengthen or weaken. Buying the spread means buying the Soybean Oil futures and selling the Palm Oil futures, and vice versa. The following hypothetical example shows how BOPO spread trading can be executed.
On September 3, a trader wishes to establish a short position in the BOPO spread for a quantity of 3,000 metric tons. The trader sells 110 lots of Soybean Oil futures at 29.29 cents per pound and buys 120 lots of USD Malaysian Crude Palm Oil futures at 537.75 dollars per metric ton2. The trader later unwinds the positions on December 31, trading Soybean Oil futures at 34.49 cents per pound and Crude Palm Oil futures at 748 dollars per metric ton. The BOPO spread in dollar/metric ton term moved down from $107.98 to $12.37. This translates into a total profit of $287,550 in our example. Conversely, if the trader chose to take a long position in the spread, the profit and loss in the two futures contracts would reverse and result in a total loss of $287,550.
| Futures leg 1 | Futures leg 2 | Total Profit/Loss | |
|---|---|---|---|
| Sep 3rd | Sells 110 lots of January Soybean Oil futures for at a price of 29.29 cents per pound | Buys 120 lots of January Crude Palm Oil futures at a price of $537.75 per metric ton | |
| Dec 31st | Buys 110 lots of January Soybean Oil futures to close out position at 34.49 cents per pound | Sells 120 lots of January Crude Palm Oil futures to close out position at $748 per metric ton | |
| Profit/Loss | Loss: 110 lots x 60,000 pounds x 5.2 cents per pound = 343,200 dollars | Profit: 120 lots x 25 metric tons x 210.25 dollars per metric ton = 630,750 dollars | Total Profit: 630,750 – 343,200 = 287,550 dollars |
Asia’s transportation fuel markets are based primarily on palm oil with no viable crop-based feedstocks like rapeseed oil available. Biodiesel is closely linked to the low sulfur gasoil markets, reflecting the fact that biodiesel is a feedstock to road diesel (low sulfur gasoil). Therefore, the futures spread between both products is actively traded. This spread is referred to as the Palm Oil vs Low Sulphur Gasoil or POGO.
The POGO spread can be seen as one indicator of whether the biodiesel blending into gasoil is economically viable. Typically, a weaker spread can indicate that palm oil becomes more attractive as blend feedstock to biodiesel. In some other regions such as Europe where biodiesel consumption is significant, blenders may also consider the cost of alternative feedstocks such as rapeseed or soybeans or fatty acid methyl ester (FAME). Second generate waste biofuels are expected to become more widely used due to the second phase of the Renewable Energy Directive (in the EU).
The chart below shows the price history of POGO spread since 2015. The strengthening in the energy segment, and later the palm oil price rally together, as depicted the general price trend of the spread, making the price move between positive and negative territories multiple times.
Chart 2 – Multiple reverses of the POGO spread
Source: CME Group
The Bursa Malaysia Crude Palm Oil - Gasoil Spread futures (Code POG)3 listed on CME is a financially settled contract that tracks the price differential between the European Low Sulphur Gasoil and Malaysian Crude Palm Oil. The contract is for 25 metric tons and the minimum tick size is $0.25 per metric ton.
The other way to establish positions in the POGO spread is by trading the corresponding futures contracts, like in the previous BOPO spread example. For instance, a firm that uses palm oil as the feedstock to produce biodiesel has price exposure to both palm oil and gasoil. They may wish to buy or sell the spread depending on their view on the spread. Here buying the spread means buying the Crude Palm Oil futures and selling the Gasoil futures, and selling the spread means selling the Crude Palm Oil futures and buying the Gasoil futures. The following example shows how the POGO spread trading could be executed.
On September 3, a biodiesel blender establishes a long position in the POGO spread for a quantity of 2,000 metric tons. They buy 80 lots of USD Malaysian Crude Palm Oil futures at 537.75 dollars per metric ton and sell 2 lots of European Low Sulphur Gasoil Financial futures at 543.75 dollars per metric ton4. The firm later unwinds the positions on December 31, trading Crude Palm Oil futures at 748 dollars per metric ton and Gasoil futures at 614 dollars per metric ton. The POGO spread widened $138.54, from -$4.36 to $134.18 per metric ton. This translates into a total profit of $277,092 in our example. Conversely, if the blender chose to create a short position in the spread, the profit and loss in the two futures contracts would flip and result in a total loss of $277,092.
| Futures leg 1 | Futures leg 2 | Total Profit/Loss | |
|---|---|---|---|
| Sep 3rd | Buy 80 lots of January Crude Palm Oil futures for at a price of 537.75 dollars per metric ton | Sell 2 lots of Gasoil futures at a price of $542.11 per metric ton | |
| Dec 31st | Sell 80 lots of January Soybean Oil futures to close out position at 748 dollars per metric ton | Buy 2 lots of January Crude Palm Oil futures to close out position at $613.81 per metric ton | |
| Profit/Loss | Loss: 80 lots x 25 metric ton x 210.25 dollars per metric ton = 420,500 dollars | Profit: 2 lots x 1,000 metric tons x 71.704 dollars per metric ton = 143,408 dollars | Total Profit: 420,500 – 143,408 = 277,092 dollars |
Palm oil is the largest vegetable oil market in the world, competing with soybean oil for global market share. The use of vegetable oil as biodiesel feedstock links the palm oil and gasoil markets. The BOPO spread and POGO spread represent the connection between these commodities and serve as important market indicators.
As the market conditions changed and supply/demand rebalanced, we have seen the prices in BOPO and POGO both moving in large scale. The increased volatilities present not only the need for risk management but also trading opportunities in these inter-commodities spreads.
1 Soybean oil price is converted to USD per metric ton using a conversion factor of 1mt = 2,204.622 pounds.
2 One lot of Soybean Oil futures = 60,000 pounds or 27.22 metric tons. The tick size is $0.0001 per pound. USD Malaysian Crude Palm Oil futures = 25 metric tons and the tick size is $0.25. 110 lots of soybean oil futures provide an exposure of about 2,994 metric tons and 120 lots of crude palm oil futures represent 3,000 metric tons. The difference in the contract sizes and price quotations of the two contracts means the gain/loss from similar price movements in the two markets does not exactly offset with each other.
4 One lot of European Low Sulphur Gasoil Financial Futures = 1,000 metric tons. The tick size is $0.001 per metric ton.
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