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Short Brent/Long WTI: an "obvious" trade?

Tuesday, Feb 15 2011 by
17
Short BrentLong WTI an obvious trade

Emptyend recently mentioned an FT article which I had previously read, commenting on the disparity in the oil price for WTI crude and Brent.

The price difference between the world’s top oil benchmarks reached an intraday record of more than $16 a barrel, doubling in three weeks, as West Texas Intermediate oil disconnects from top global oil references Brent and Dubai. The spread fell back to just above $14...

Historically, Brent trades at a discount to WTI as the Brent blend is slightly lower "quality" than WTI (West Texas Intermediate).

It occurred to me that, surely, this pricing anomaly cannot persist forever? Eventually, physical traders must surely take advantage and buy cheap oil from Cushing and sell it at a substantial profit on the world market? This Bloomberg article comments on the anomaly further:

Oil Supplies Rise in Survey on Cushing Pipeline: Energy Markets

U.S. crude stockpiles rose for a fifth week as TransCanada Corp. completed an extension of a pipeline to Cushing, Oklahoma, adding to a glut at the country’s biggest oil-trading hub, a Bloomberg News survey showed.

U.S. Oil Glut May Be Eased by Seaway Pipeline Reversal, JBC Says

A reversal of the Seaway Crude Pipeline System may reduce the record discount U.S. benchmark West Texas Intermediate incurred versus North Sea Brent, according to Vienna-based researcher JBC Energy GmbH.

The latter headline illustrating the point that eventually, physical oil will be moved in the most profitable direction. This seems to me to open up an obvious and relatively low risk trade: to go long WTI and short Brent. I have duly done so (in very modest size to begin with) on the April contract. Should the anomaly not have corrected before expiry in late March, I intend to roll these contracts.

Here is a table of recent closing prices for these contracts.



Daily close

Brent WTI Spread




01-Feb 101.70 93.77 7.93
02-Feb 102.80 93.72 9.08
03-Feb 102.27 93.28 8.99
04-Feb 100.37 91.92 8.45
07-Feb 99.87 90.62 9.25
08-Feb 100.87 90.56 10.31
09-Feb 102.52 90.32 12.20
10-Feb 102.25 90.78 11.47
11-Feb 101.35 89.07 12.28
14-Feb 103.01 88.82 14.19

 

I have managed to open my trade today with a spread of $14.18. Let's see how it goes. :0)

Further Research and Data

The above represents my initial view, data and knowledge on opening this trade, for reference. And it may turn out to be naive... Below, I will maintain my table of spread data for the April WTI contract and the Brent May one , going forward. [see later for why I have switched the Brent contract to the May one].

 

    Daily close
  Brent (May) WTI (Apr) Spread
       
01-Feb 102.15 93.77 8.38
02-Feb 102.96 93.72 9.24
03-Feb 102.49 93.28 9.21
04-Feb 100.63 91.92 8.71
07-Feb 100.37 90.62 9.75
08-Feb 101.01 90.56 10.45
09-Feb 102.72 90.32 12.40
10-Feb 101.82 90.78 11.04
11-Feb 101.30 89.07 12.23
14-Feb 103.41 88.82 14.59
15-Feb 101.91 87.66 14.25
16-Feb 104.16 87.96 16.20
17-Feb 103.82 89.00 14.83
18-Feb 103.43 89.90 13.53
21-Feb 108.09 95.39 12.70
22-Feb 106.53 95.37 11.16
23-Feb 112.15 98.97 13.18
24-Feb 111.12 96.73 14.39
25-Feb 112.32 98.16 14.16
28-Feb 111.86 96.87 14.99
01-Mar 116.47 100.58 15.89
02-Mar 116.23 102.43 13.80
03-Mar 114.66 101.91 12.75

Many thanks to the readers that have pointed out possible flaws in my thesis, helping to steer me in the right direction for further research.

Physical Arbitrage

As mentioned above, the thesis behind this trade is that the spread cannot widen forever and that eventually, physical oil traders will take over and arbitrage the spread away. What does that mean, in practice? Considering the April WTI contract that I am buying, it means that they will also buy those contracts, take delivery of the oil at the contract price and arrange for shipment to Europe or Asia. Simultaneously, they would sell, say, the Brent May (or later) contracts, so that they know what prices they will receive for the oil when it arrives. It is possible that the oil has to be blended before delivery, but I doubt it because Brent is slightly lower quality than WTI, so WTI oil should meet the Brent spec. I find it hard to imagine that shipping costs would be anything like $10/bbl, so buying oil for $87/bbl, shipping it, and selling it a month or two later for a guaranteed $101/bbl would be a highly profitable and negligible risk trade. That process will eventually reduce the spread.

Considering this subtelty (i.e. the delay between buying and selling), it actually makes more sense to short the May Brent contract and remain long the April WTI one. I have rolled my April Brent short at a cost of 18c into the May contract, taking advantage of the current small Brent contango.

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That's the theory, in outline. The question is, can it work in practice? I have heard a commentator say that there is no aribitrage between Brent and WTI, which is what has led to this "spread blowout". So, I thought I'd check that out, and quickly came across this (see post by "gekko21"):

The Brent-WTI (Atlantic Arb) is the most commonly traded oil arb in the world with traders being able to take North Sea Brent and ship it across the Atlantic depending on WTI prices and freight costs----the trade can also go the other way with WTI going to Europe.

Now of course, this is only from a post on a BB, so may or may not be true - but it appears authoritative to me and I tend to believe it unless anyone can provide better evidence to the contrary.

The WTI Contract

Next to check is whether there are any issues concerning settlement of the contracts I'm trading. Here, I can get definitive answers, from the horses mouth:

(A) Delivery shall be made F.O.B. at any pipeline or storage facility in Cushing, Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing storage. Delivery shall be made in accordance with all applicable Federal executive orders and all applicable Federal, State and local laws and regulations. For the purposes of this Rule, the term F.O.B. shall mean a delivery in which the seller:
  • provides light "sweet" crude oil to the point of connection between seller's incoming and buyer's outgoing pipeline or storage facility which is free of all liens, encumbrances, unpaid taxes, fees and other charges;
  • in the event of the buyer's election to take delivery by interfacility transfer ("pumpover") to either TEPPCO, Cushing or Equilon Pipeline Company LLC, Cushing, from seller's delivery facility, bears the lesser of the pumpover charge applicable for pumpover from seller's delivery facility to TEPPCO or Equilon Pipeline Company LLC;
  • retains title to and bears the risk of loss for the product to the point of connection between the buyer's outgoing and the seller's incoming pipeline or storage facility.
(B) At buyer's option, such delivery shall be made by any of the following methods:
  • By interfacility transfer ("pumpover") into a designated pipeline or storage facility with access to seller's incoming pipeline or storage facility.
  • By in-tank transfer of title to the buyer without physical movement of product; if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer.

(C) All deliveries made in accordance with these rules shall be final and there shall be no appeal.

Clearly only physical oil traders can hold the contract to settlement and actually take delivery of the oil, as specified above. Rulebook Chapter 200 specifies the oil blend/purity that is acceptable for delivery - so oil containing "gunk" would not be acceptable!

Pipelines

So, now to the crux of the matter: how easy is it to get oil in and out of Cushing? Wikipedia proves a nice overview of Cushing:

Cushing is a major hub in oil supply connecting the Gulf Coast suppliers with northern consumers. Cushing is famous as a price settlement point for West Texas Intermediate on the New York Mercantile Exchange[4] and has been cited[7] as the most significant trading hub for crude oil in North America. As of 2007, Cushing holds 5 to 10 percent of the total U.S. crude inventory. Signs made of a pipe and valve on the major highways near town proclaim Cushing to be the "Pipeline Crossroads of the World", and the town is surrounded by several tank farms. Most storage tanks are owned by four entities: oil giant BP, and energy-transport and logistics firms Enbridge Energy Partners, Plains All American Pipeline, and SemGroup Energy Partners. On July 13, 2010, BP announced it will sell its assets in Cushing to Magellan Midstream Partners.[8]

Next, I thought I ought to get a better understanding of the US pipeline network and Cushing's location within it. Click on the thumbnail below to see it properly:

The "key" to the pipeline numbers is here: http://www.theodora.com/pipelines/united_states_pipelines.html

As can be seen from the map, Cushing is around 400miles due north of Houston and the GoM coast, where import/export pipelines converge.

Now, I note the article highlighted by nigelpm, which suggests that Cushing will remain oversupplied and WTI depressed for a very long time. I am sceptical of this, for two reasons. Firstly, the article itself illustrates that with such a large spread, producers will use any means they can to get oil to export terminals where they can achieve better prices. African4life makes the point that pipleines can be "turned around" but that this takes time. This brings me onto my second reason for scepticism: observing the data tabulated above, the WTI/Brent spread has built up awfully quickly. This seems to me more characteristic of a  temporary "bubble" in the spead than a long term shift. If the spread remains so large, surely Canadian producers in Alberta can get their oil out to a terminal on the pacific coast for shipment to Asia, rather than accepting way below market prices in the US? There are plenty of pipelines going to oil terminals on the coast but I suspect that some of them are flowing in the "wrong" direction and it takes time to turn them around - but that's a matter of weeks or a month or two, rather than years. [as the Wiki article mentions, the normal flow of oil is from Texas northwards]

I do not have the detailed information on the pipeline network to be truly confident of this hypothesis (or I'd enter this trade in size!). I will use market behaviour of the spread to guide me.

WTI Contango

Nigelpm made a very good point about the WTI contango being much steeper than the Brent one. ISTM that this is a direct consequence of the current Cushing oversupply anomaly: physical traders will want to buy longer dated contracts because they do not yet have the capacity to export sufficient oil that arrives at Cushing in the near future. This situation should change over time, if my hypothesis is right. If not the contango will eventually kill the potential profitability of this trade.

Mark


Filed Under: Oil, Trading,

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172 Comments on this Article show/hide all

nigelpm 7th Apr '11 73 of 172
1

FWIW, for those that trade this via spreadbets, CMC have stated to me that they are likely to offer a synthetic WTI/Brent Spread Instrument shortly.

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marben100 8th Apr '11 74 of 172

Well I'm out again at an average of $12.05, taking a modest profit. The spread has been widening again consistently since late yesterday and my trailing stop has now been hit.

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MaxCashflow 8th Apr '11 75 of 172

I took my eye off the ball today and got out at $12.50 for a smaller profit :-). Will try to reenter when trend reverses.

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MaxCashflow 8th Apr '11 76 of 172

Interesting - over the last month or so some of the best exit points have been on Thursdays. Friday prayer days really do seem to affect the spread.

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nigelpm 8th Apr '11 77 of 172
1

Doubled up at $14 (using CMC - they have "cash" commodities - which take note of the contango in the overnight spread rollover - if anyone is wondering!)

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MaxCashflow 8th Apr '11 78 of 172

I've reentered the June contracts at $12.7 after seeing a high of $13. I'll have to take a look at CMC - sounds interesting.

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marben100 9th Apr '11 79 of 172

In reply to MaxCashflow, post #78

Hi Max,

You'll have to look at the overnight charges carefully - I think you'll find that they cost at least as much (over an equivalent period) as rolling the contract.

By trading "the spread that I see" actively and operating on the front month + 1 contract, the contango is not really much of an issue for me any more. In fact a differential contango seem to actually work in my favour, when the front month rolls of other traders drive up the front + 1 WTI contract. That often offers a good exit point, allowing me come back later, opening positions on the subsequent month's contracts.

I'm away for a couple of weeks so will not be able to trade. Shame, because it looks like this could be a good time to make money. Nigelpm will probably do very nicely from his position opened at a $14 spread.

Best regards,

Mark

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MaxCashflow 11th Apr '11 80 of 172
1

Interesting, I had wondered if the roll influenced the spread positively for us.

I've now exited again for the time being having hit a virtual stop at $12.5 - looks like the spread is trending higher again for the time being.

Have a good time away, hope it is relaxing!

Cheers, Max

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nigelpm 14th Apr '11 81 of 172
1

Just what is it with this trade and Thursdays?

I guess it's become a self fulfilling prophecy.

I managed to further increase my position earlier in the week at 15.8 and have closed out that portion now at 14.4.

Still holding plenty and expect further movement inwards.

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emptyend 15th Apr '11 82 of 172
2

Just what is it with this trade and Thursdays?

I suspect that it is something to do with Wednesdays being the day when US oil stocks figures are published and Fridays being the day of prayer/riot in the ME......

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MaxCashflow 19th Apr '11 83 of 172
2

I'm now out at $12.7 having doubled up at $15. I wanted to exit because I think on Bank Holiday Monday Brent will be closed whilst WTI is trading, and trading on margin I didn't want to be exposed to one side alone for a whole day.

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nigelpm 10th May '11 84 of 172

Opened up again at 14.4.

For the record I got out at a very small profit last trade.

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nigelpm 25th May '11 85 of 172
2

Doubled at 15.2 - very surprised there are no inroads on this.

ee's early comment RE: slow movement would appear to have been very poingnant.

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emptyend 25th May '11 86 of 172
1

In reply to nigelpm, post #85

very surprised there are no inroads

Why? There are massive structural reasons why the WTI and Brent contracts cannot be arbitraged in the way that they used to be. The oversupply at Cushing storage is what is creating the spread - so until more storage is built and/or until railroads/pipelines are built to divert supply elsewhere then the spread will remain wide.

This stuff will get built, of course, but if you are taking a position then you should be on top of when that is likely to happen! Perhaps worth following up the items mentioned here?

....but don't bank on being able to make much money - the timescales should be more or less all in the price of the strip.

ee

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nigelpm 25th May '11 87 of 172
1


Why? There are massive structural reasons why the WTI and Brent contracts cannot be arbitraged in the way that they used to be. The oversupply at Cushing storage is what is creating the spread - so until more storage is built and/or until railroads/pipelines are built to divert supply elsewhere then the spread will remain wide.

This stuff will get built, of course, but if you are taking a position then you should be on top of when that is likely to happen! Perhaps worth following up the items mentioned here?

....but don't bank on being able to make much money - the timescales should be more or less all in the price of the strip.


Simple economics suggest to me that the anomoly cannot continue for more than a few months although I take your points.

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emptyend 26th May '11 88 of 172
2

In reply to nigelpm, post #87

Simple economics suggest to me that the anomoly cannot continue

This bit I can certainly agree with....but.....

for more than a few months

....this is just too optimistic, given the circumstances of needing to build new physical infrastructure. At some point though the completion of such facilities will start to loom on the horizon and the gap will then close - but it will be difficult for those without a natural position in the physical to profit from it (because those who have phsical positions will be "all over" the trade in massive size anyway and ensure that expectations at every point in time are reasonably priced-in).

Anyway....enough from me on that.

cheers

ee

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marben100 26th May '11 89 of 172
1

In reply to emptyend, post #88

given the circumstances of needing to build new physical infrastructure

Not so sure that's correct, ee. A potential export route alreay exists:  the Seaway pipeline - but it's currently flowing the wrong way (i.e. North towards Cushing, instead of South, away from it). This article explains the "game" of the midcontinental refiners: http://streetwiseprofessor.com/?p=4878

Sounds to me like all it would take is a handshake to crush the spread. ;0)

Haven't had time to rebuild my hand-crafted charts since returning from a break (it's AGM season) but look forward to doing so and playing this game again. By timing entries and exits I found I could make a steady profit - and good money can be made when that handshake happens.

Cheers,

Mark

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nigelpm 26th May '11 90 of 172

In reply to marben100, post #89

Yes, good points Mark.

Ultimately, it is absolutely nuts that one can pay $15 more (or 15%) for an identical (well actually slightly inferior) product - clearly though short term anomolies are evident in all markets.

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marben100 26th May '11 91 of 172

In reply to nigelpm, post #90

Well, I just hope Aminex is sending its Shoats oil south rather that north. All we need is to get a bit more out of the ground and sell it at Gulf Coast prices. That'd help somewhat. :0)

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mallwood 29th May '11 92 of 172
2

Texas pipeline approved:

http://www.reuters.com/article/2011/04/26/pipeline-enterprise-idUSN2626524920110426

Analysts expect WTI's strong discount to Brent -- which ballooned out to over $17 a barrel in February and currently stands at near $12 -- as well as its discount to crude delivered to the Gulf Coast to last at least until 2013 when new pipelines are online.

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About marben100

Marben100

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I am a full-time private investor... with a little trading on the side (generally small-scale arbitrage in specialist niches). Previously, I spent 24 years in the IT industry, 13 of those running my own IT services firm. I invested as a "hobby" for 20 years before turning it into a full-time occupation in 2004. I really enjoy the "research" side of investing, finding out about varied businesses and industries and learning what makes them tick. Since going "full-time" I have learnt an awful lot from some very erudite investors & professionals who are kind enough to share their expertise in electronc forums such as this. I can now count a number of them as my friends, having had the opportunity to meet them in the real world, as well as this virtual one! I try to pay back the debt I owe by sharing what I've learnt and I always value constructive criticism to correct my errors and misapprehensions! I am a Director of ShareSoc, the UK organisation for individual shareholders. See below for details.     more »


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