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.

 Special Offer: Invest like Buffett, Slater and Greenblatt. Click here for details »

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,

About the Author's Website

marben100 Profile Image Promotional
ShareSoc - UK Individual Shareholders' Society

ShareSoc is a not-for-profit campaigning organisation, promoting individual share ownership, fighting for shareholder rights and providing educational resources to investors. ...read more or visit website »


Disclaimer:  

The author may hold shares in this company, all opinions are his own and you should check any statements that appear factual and not rely on them before making an investment decision. The author is NOT a qualified analyst nor authorised to give investment advice. Whilst the author is a director of ShareSoc, all views expressed are entirely his own and not necessarily those of ShareSoc.


Do you like this Post?
Yes
No
17 thumbs up
0 thumbs down
Share this post with friends




172 Comments on this Article show/hide all

African4Life 7th Jun '11 93 of 172
1

Some new highs being hit on this arbitrage...

| Link | Share | 1 reply
MaxCashflow 7th Jun '11 94 of 172
1

I've just entered on the August contracts at a $16 spread.

| Link | Share
nigelpm 7th Jun '11 95 of 172

Yeah, quite impressive TBH. Added further @ 17.7

| Link | Share
nigelpm 7th Jun '11 96 of 172

http://www.ft.com/cms/s/0/074c9e26-9133-11e0-9668-00144feab49a.html?ftcamp=rss#axzz1OchQSwsS



The disparity between Brent and WTI has thrown traditional energy hedging strategies into disarray. Delta Air Lines this year said it had shifted most of its WTI hedging positions into Brent and heating oil.



They won't be the only ones to do this.

My guess is at some point the spread is going to deflate quite quickly through speculative positions being built up - given the huge spread and thus cost of hold being about 1$ a month I'm willing wait for that moment.

 

Fascinating stuff.

| Link | Share
tiswas 10th Jun '11 97 of 172

Just about to hit $19 spread.

What was the high?

| Link | Share
nigelpm 10th Jun '11 98 of 172

Amazing, gone over $19 (all time high) and seemigly headed higher.

I've lost the urge to fight it so won't be adding to the position just yet!

| Link | Share
tiswas 10th Jun '11 99 of 172

http://www.bloomberg.com/news/2011-06-10/oil-falls-first-day-in-four-in-new-york-on-signals-economic-growth-to-slow.html

Brent, the European benchmark contract, traded at a record $18.90 premium to U.S. futures today. The spread between the two grades has climbed from $3.29 at the beginning of the year as the Libyan rebellion curbed global supplies of light, sweet crude, or oil with low density and sulfur content.

Equipment problems and planned maintenance are expected to curb production at the Buzzard oil field in the North Sea until the end of July, according to Calgary-based operator Nexen Inc.

“The Libyan disruption has been a major reason for the Brent premium,” Mueller said. “Maintenance at the Buzzard field has both reduced the amount of Brent oil and increased its quality, adding to its price. We also have too much oil at Cushing, depressing the price of WTI.”

Supplies of oil at Cushing, Oklahoma, the delivery point for the New York-traded West Texas Intermediate grade, rose to 41.9 million barrels in the week ended April 8, the highest level since at least 2004, when the Energy Department began tracking stockpiles at the hub.

| Link | Share
nigelpm 11th Jun '11 100 of 172
1


Supplies of oil at Cushing, Oklahoma, the delivery point for the New York-traded West Texas Intermediate grade, rose to 41.9 million barrels in the week ended April 8, the highest level since at least 2004, when the Energy Department began tracking stockpiles at the hub.

worth noting that's months out of date!


http://af.reuters.com/article/energyOilNews/idAFN0823951820110608

Inventories at the key Cushing, Oklahoma terminal fell 1.02 million
barrels to 38.9 million barrels. Cushing is the delivery point for the New
York Mercantile Exchange's benchmark West Texas Intermediate crude futures
contract.

| Link | Share | 1 reply
marben100 13th Jun '11 101 of 172

In reply to nigelpm, post #100

Thanks for highlighting guys. I've now brought my charts up to date (for August WTI vs August Brent)... and the spread still appears to be widening. The wider it gets, the more spectacular the eventual fall will be. I noted from past experience that the spread often widens towards contract expiry and this is the week for July WTI contract expiry.

Watching and waiting...

| Link | Share
bugsmunny 13th Jun '11 102 of 172

How much does it cost to buy WTI and sell it in Europe? Can it be done physically?

Is this a stupid question? I'm just wondering if there is an upper-limit on the divergence in prices.

In my mind $20 seems like a pretty big incentive.

I've taken a small short on Brent and a long on WTI

B

| Link | Share | 2 replies
marben100 13th Jun '11 103 of 172

In reply to bugsmunny, post #102

Hi Bugs,

The problem is physically getting it out of Cushing. See the thread header for details of Cushing's location and pipeline issues. Even as near as the Texas coast (where there are huge oil terminal facilities), I understand light sweet crude trades at prices pretty close to Brent.

With a $20 spread, it'd virtually be economic to transport the stuff with a human chain of buckets!

Anyhoo... from my charts, it looks like the spread may be flattening off and perhaps declining again, so I've dipped my toe in with the August contracts at an opening spread of $19.74 & a tightish "virtual" stop, in case a figure slightly above $20 didn't turn out to be the peak! If the spread gets into a proper downtrend I'll add to that position.

Cheers,

Mark

| Link | Share | 1 reply
nigelpm 13th Jun '11 104 of 172

In reply to bugsmunny, post #102

Yeah, by most google searches/info you'll get people reckoning it's somewhere between $10 and $15.

IMHO, what we are seeing now is a pure speculation feeding frenzy which will blow out at some point.

As you'll see from my post above oil at cushing did actually decline by 1m barrels last week so the speculation is driving the spread not hard facts.

| Link | Share
tiswas 13th Jun '11 105 of 172

As you'll see from my post above oil at cushing did actually decline by 1m barrels last week so the speculation is driving the spread not hard facts.

Sorry Nigel, but as a newbie to this potential trade I don't understand your comments, particularly when you are "speculating" that the gap will narrow!

Just because Cushing stocks fell a bit doesn't change the fact that they seem to have an abundance of the stuff whereas we are supposedly missing out on Libya's production and I also read somewhere that pipelines in the north sea are due to close for some reason or another. (Was it to clear mines or routine maintenance?)

Do we have an inventories equivalent number here?

21 bucks and a bit on the cash price at the mo and still watching trying to make sense of it all!

| Link | Share | 1 reply
marben100 13th Jun '11 106 of 172

In reply to marben100, post #103

Hmmm... stopped out on that attempt. Back to watching & waiting.

| Link | Share
nigelpm 13th Jun '11 107 of 172

In reply to tiswas, post #105


Just because Cushing stocks fell a bit doesn't change the fact that they seem to have an abundance of the stuff whereas we are supposedly missing out on Libya's production and I also read somewhere that pipelines in the north sea are due to close for some reason or another. (Was it to clear mines or routine maintenance?)


The point is two-fold:

1) Stocks have been increasing week after week until this point.

2) Perhaps the decline is showing evidence that oil is being shipped out of Cushing due to the "crazy" spread

Out at $22 now!

 

http://s.wsj.net/public/resources/images/OB-OH573_brentw_G_20110613135232.jpg

| Link | Share
bugsmunny 14th Jun '11 108 of 172

I don't generally use stops because there's a large random element to price movements. Which means that if you use tight stops you end up throwing the dice.

The point IMO is that the price differential is unsustainable and that as it moves away from the mean it's more likely to revert than not.

So I will add to my position.

| Link | Share | 1 reply
marben100 14th Jun '11 109 of 172
1

In reply to bugsmunny, post #108

I don't use stops for investment in shares, where my risk is strictly limited to the amount I invest. Commodities trading, however, is a different matter. In this trade, in particular, I have found that I can make more money by monitoring charts carefully. There is no telling how long this anomaly can last (it has already lasted far longer than I thought likely) or how high it can go (it was ludcrous at $15 and is even more ludicrous now) and by holding a position indefinitely, you incur monthly roll costs*. Some have suggested it may take many months for the spread to normalise, until the necessary logistics are put in place to get oil out of Cushing. There are also strong vested interests involved, with the Seaway pipline being controlled by ConocoPhilips who own refineries close to Cushing and benefit strongly from an enhanced crack spread by keeping the Cushing crude price artificially insulated from world markets. Note that this also benefits Washington by helping to hold gasoline prices down: there are fewer bigger political hot potatoes in the US than high gas prices!

There is no evidence yet that the uptrend in the spread has broken and it remains above the level I was stopped out at. NB my stop is a virtual one, which I have to execute manually - so I won't be stopped out by a very brief glitch. My strategy is based on montoring a two-hour chart of the spread and waiting for a specific indication of the current uptrend reversing. As it happens, I've found that that chart gives a pretty clear picture of the trend in the spread. I add to my position (using trailing stop losses to guarantee profits) as the downtrend continues. Sticking to disciplined trading rules is important.

*July-August Brent is currently in backwardation to the tune of $0.70, whereas July-August WTI is in contango by $0.515, so effectively you pay $1.215 each month you remain short Brent and long WTI.


However, we each have to work out what strategy works best for our own styles.

Cheers,

Mark

| Link | Share | 1 reply
marben100 14th Jun '11 110 of 172

In reply to marben100, post #109

PS my stop is set above the previous two-hour high point on my chart - so if it is breached it invalidates the hypothesis that the uptrend is broken!

| Link | Share
nigelpm 14th Jun '11 111 of 172
1

The questions here must be :

1) who can take advantage of the spread?

2) Are they better to wait for the spread to get even more nuts before "investing"

3) Who is currently losing out/gaining from the spread?

| Link | Share | 1 reply
bugsmunny 14th Jun '11 112 of 172

Good points.

I think there is some merit in charts for commodities.

But now we have a situation with a ridiculous spread, the forces trying to return it to a more sensible level must be strong. But yes I guess it might worsen in the "short term."

I usually open several small bets with several limits. Random movements of a 100 to 300 points is not so unusual and try to close before rolling into the next contract to avoid extra costs beyond the initial spread.

If I can bank a few hundred pounds a week on that basis it's fine for relatively minimal effort.

Have been doing the same for FTSE shorts hedged against my portie with limits rather than stops to good effect FWIW

Bugs








| Link | Share

What's your view on this article? to Comment Now

 
 
You are feeling neutral

Use the £ sign in front of a ticker to turn £VOD into Vodafone PLC

You can track all @StockoChat comments via Twitter


About marben100

Marben100

Follow

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 »


Stock Picking Tutorial Centre


Related Content
Lapacho adds to Jacaranda drilling
Lapacho adds to Jacaranda drilling
President Energy 24th Jul

New product strategy paying off
New product strategy paying off
K3 Business Technology 14th Jul

Trinidad success just the beginning
Trinidad success just the beginning
Leni Gas and Oil 3rd Jul




Stock Picking Simplified

Stockopedia takes your stock picking to the next level with cutting edge Stock Reports & Screening tools.


Get started
or Take a Tour to find out more.
Join us at the London Investor Show next Friday at Olympia