By Aaron Fennell
Many investors are interested in profiting from their views on the price of crude oil, but may not have considered that trading price differentials between different products. West Texas Intermediate (WTI) and Brent crude oil, offer compelling opportunities for traders.

Two main types of crude oil products traded in the marketplace are based on location and grade. The one we normally trade in North America is West Texas Intermediate, the type of oil entering the United States through the Gulf of Mexico. Brent crude oil is the product located in the North Sea between Scotland and Norway, and is essentially the benchmark for the European market.

WTI has slightly lower sulfur content and is therefore easier to refine to meet emissions requirements in place in most Western countries. Therefore, it demands a higher price. The West Texas Intermediate crude has an average historical premium of $1.40 over Brent. However we often see the prices go out of alignment and this often has to do with location and transportation bottlenecks. If crude oil is subject to a shortage in one region and there is an excess supply in another, oil will eventually be redirected, depending on the shipping industry’s capacity to move it around. This redistribution can take a few weeks or months, but over the medium term the market naturally rebalance. Oil tankers are basically conducting arbitrage as they move their  oil around the world. In the meantime, short-term market prices can get out of line.

Many futures traders are familiar with the light sweet crude contract traded at CME Group/NYMEX. However, the ICE Futures exchange offers electronic trading on both the WTI and Brent Crude Oil on one platform, allowing you to trade spreads on these products. The nice thing about trading both these products on ICE is that is has a pretty sophisticated algorithm for spread trading. You can get both sides filled on one order. Another advantage of trading these oil spreads on one exchange is that the margin requirement on the pair is much lower than trading the individual outright futures contracts. You can utilize more leverage to trade the two pricing points of these markets in a non-directional fashion. You can also monitor freight rates between the North Sea and Gulf of Mexico, and observe how the differential changes when those rates are high or low. When freight rates are high, you can expect a more volatile price differential.

ICE Brent Crude Specifications (see www.theice.com)

Contract size: 1,000 barrels
Quotation: U.S. dollars and cents per barrel.
Minimum Price Flux: One cent per barrel, equivalent to a tick value of $10. A $1 move in brent crude = $1,000.
U.K trading hours: Open 01:00 London local time (23:00 Sundays).
EST hours: Open 20:00 (8:00 p.m.) (18:00 Sundays).
Chicago hours: Open 19:00 (7:00 p.m.) (17:00 Sundays).

The contract is cash settled, unlike the similar NYMEX light sweet crude many futures traders are more familiar with, which deals with delivery of the physical commodity.

ICE WTI Crude Specifications

Contract size 1,000 barrels
Quotation: U.S. dollars and cents per barrel
Minimum price Flux: One cent per barrel; equivalent to a tick value of $10. A $1 move in WTI crude = $1,000.
Open Monday morning/Sunday evening
U.K. 23:00 London time
EST hours: Open 18:00 (6:00 p.m.)
CT hours: Open 17:00 (5:00 p.m.)
Like the brent contract, ICE WTI contract is also cash-settled.

Looking at price history, you can see how the historical price differential between WTI and Brent is about $1.47 a barrel. You can also see how volatility has also increased over time. On a percentage basis, a $5 difference used to be significant back in the 1980s and early 1990s, but over time, that has increased with the range as crude oil climbed to higher levels. It’s important to know how wide the price differential can get.

Let’s now look at futures contracts. You can see the June front-month WTI contract was  trading at a discount to Brent in mid- to late-April. One might think that European crude oil prices would be falling because of the situation in Iceland at that time, when a volcanic eruption grounded all the jets in European airspace for many days. However, the opposite was actually the case. You can see how the fall and winter contracts turn to more normal patterns with a small premium to WTI. I think the opportunity for investors and traders exists in the farther-dated contracts. Oil companies will structure oil deliveries to take advantage of the higher pricing in Europe, if that type of imbalance remains (which isn’t likely).  The futures should therefore eventually reflect the normal historical relationship over time.

Looking at a daily chart of the futures spread in mid-April (near expiry), you can see how it has fluctuated. Going back to August it was trading at -0.75, and moved back and forth, in and out of positive territory before sliding back again. When the market is reaching expiration, you have to be careful. There isn’t enough time for an inverted market like this to correct itself through normal arbitrage. It’s possible that if there is a surplus of WTI, it will likely extend through expiry. However, if you were trading back in August of 2009, knowing WTI normally trades at a premium, you might have considered basing a trade on that return to normal conditions above $1. Hopefully you would’ve taken your profits and gotten out of the trade when that occurred.

Looking back even further, we can find more examples of these market fluctuations. A year prior to expiry of the December 2009 contract, this spread was also inverted, at about -$2.It didn’t take long before it moved into a premium of about $1, then moved back to discount for a short period of time, and ultimately expired near it’s normal premium levels.

There is certainly a range within which this spread is likely to remain.  By understanding normal equilibrium, you can trade within those bands. That’s not to say there’s no risk involved when trading this spread, but if you know what the normal price relationship you can find some superior opportunities over simplistic directional trades. These pricing relationships offer a more sophisticated strategy for traders to consider. If you have any questions about this topic or other markets, I encourage you to give me a call.

Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.

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