Trading opportunity WTI versus Brent

February 10, 2011 10:39 am

Their API gravity is around 40 degrees, which makes them “light” crudes. API gravity is a measure of how heavy/light a petroleum liquid is compared to water. If its API gravity is greater than 10, oil is lighter and it will float on water. In other words, API gravity is an inverse measure of the relative density of a petroleum liquid and the density of water, and it is used to compare the relative densities of petroleum liquids.

Brent Blend is a combination of crude oil from fifteen different oil fields located in the North Sea (widely used in Europe). This ‘Brent blend’ has an API gravity of 38.06 and therefore Brent is still called a “light” crude oil, but not quite as “light” as WTI. Brent contains about 0.37% of sulphur (making it a “sweet” crude oil), but again Brent is more sour than WTI, which contains about 0.24% of sulphur.

WTI more expensive than Brent?

According to the characteristics of WTI and Brent, it would be logical to conclude that WTI is slightly more expensive than Brent. Usually it is, or at least historically it usually was, but lately a dramatic change can be spotted: Brent is now ‘trading over’ WTI.

A trading strategy could be for instance: sell the spread (buy WTI and sell Brent) and wait until the spread turns around again to normal levels and close (liquidate) the initial spread position, resulting in a profit.

However, as you can see from the chart (based on front month future contracts), Brent has been outperforming WTI since the autumn of 2010. The spread even went up to $11.50 per barrel. So if you would have set up the spread trading strategy at a price difference of $3 (because that -based on the historicals- looked extremely likely) then you would have made a huge loss by now.

There are several reasons for this widening divergence. An ample stockpile in the US (Midwest) Cushing, Oklahoma, is one of the reasons. This caused a pressure on future (contango) prices since traders reduced the premium which they were willing to pay for later deliveries. Note: When future months are traded at higher prices, it is said that the market shows a contango structure.

The depletion of the North Sea oil fields, where Brent is being pumped, might be another explanation for the divergence in (forward) prices, because of scarcity. However, the most likely reason that the Brent-WTI spread widened even further as concerns that unrest in Egypt could spread to other nations and temporarily disrupt oil supply to Europe and Asia, while stockpiles continue to grow in the United States.

It was feared that the Suez Canal would be closed if the situation in Egypt escalated. In case of closure of this passage, oil tankers would have to ship around Africa via Cape Horn instead of straight through the Suez Canal. Ahmed El Manakhly, head of traffic for the Suez Canal Authority, stated that Egypt’s Suez Canal is open and operating normally (so far). On a daily basis more than a million barrels pass the canal.

Ideal trading opportunity

Since the spread (based on March futures contracts) between Brent and WTI reached historical high levels, this might be a golden opportunity to make money. A possible trade could be: Buy 1 WTI MCH @ $91.36 and Sell 1 Brent MCH $102.10 (selling the spread). In other words, sell the spread at a price of $10.74.

This position will prove profitable if WTI strengthens against Brent. This will certainly happen when the tension in and with respect to Egypt will fade away. Then ‘mean reversion’ will take place.

If you are right and the spread will narrow again (for instance to $7.50; possibly by WTI @ 80 and Brent @ 87.50, or maybe even WTI @ $100 and Brent @ $107.50), the spread can be covered (bought) by buying Brent and selling WTI. The profit would then be $3.24 per barrel, or (times thousand barrels per futures contract).

However, if this extreme situation continues, the spread might even widen more (but form your opinion about the changes)! It is no guarantee that the spread will narrow again. Like in outright trading positions, it is advised also to determine stop-loss levels when to close the position. For instance, if the WTI/Brent spread will widen to $12 the loss would be $1,260 per contract (($10.74-$12) * $ 1,000). The level of 12$ may be a limit at which you want to cut your loss.