SBM Trade Call complete Gap Closed on WTI – Brent

Do you remember our magazine issue in November last year? Hopefully you read our special feature starting page 15 “A Brief History of Oil”, Link here – http://issuu.com/spreadbetmagazine/docs/spreadbet-magazine-v10_generic, in particular the last part about the WTI – Brent spread, which we transcribe here:

“The most interesting situation for us, however, is in relation to the current spread between US Oil — WTI Crude & Brent Crude. Production in the US has been quite buoyant in recent years, especially from the controversial shale oil, but the pipeline infrastructure has not been able to distribute it effectively. Consequently, oil is stockpiling at Cushing. This logistics issue is in the process of being rectified, however, and we think that the excessive discount of Nymex WTI relative to Brent is likely to diminish over the coming months.

A less risky trade on the oil price is therefore potentially to Buy the WTI contract and Sell the Brent contract — the so-called WTI — Brent differential. Historically this spread has traded with a $1 – $2 price differential, but now WTI trades at a $20 discount — see chart. A pairs trade in equal proportions could be in order.”

The price difference between oil produced in the US (WTI oil or Light Sweet as it is often referred as) and Brent Crude was at extreme levels at that time, amounting to $20. But both oils are of similar quality. In fact, and as the name says, the Light Sweet is sweeter and had traditionally traded $1 or $2 above Brent Crude, but roughly speaking there’s no accountable difference between the two, and so a $20 price difference couldn’t be related to quality issues nor justified in our opinion.

Shale oil production increased substantially in the US during the last few years. According to a report from the US Energy Information Administration, the country pumped 6.5 million barrels a day of oil in 2012, the most since mid-1990s. No one was expecting such a surge in production from North Dakota and the existing pipeline infrastructure was insufficient to drive oil to refineries. US oil stockpiled at Cushing, while refineries continued to buy Brent Crude on global markets. As a result the price for Brent Crude rose while the price for the Light Sweet declined.

But it wouldn’t be wise to expect such a price difference to stay forever as problems at Cushing would be eventually solved and the pipeline adapted to the new situation. The industry expanded pipeline capacity and found some creative ways, such as using rail cars to drive the oil from MidWest US to the major demand centres. As a result, US refineries start shifting their purchases from international oil to domestic Light Sweet, contributing to the narrowing of the oil spread. From a spread of $20, the Light Sweet contract has now completely filled the gap and as we write it has, for this first time in 3 years, moved into positive territory.

With logistics now normalised in the US, the spread may revert back to the norm which was a $1-2 premium but, after a $20 ride, it is not worth speculating further on this trade – the profit has been had well and truly.

This is precisely the type of trade we play in our Titan Global Macro fund and this week took a pairs trade position in the S&P500 (short) v the Spanish IBEX (Long) which yielded a decent profit in short order. Look out also in the next edition of SBM for a piece in the Commodity Corner section on the Gold/Oil spread that we think is gearing up for a nice pairs trade too.

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