The Oil Arbitrage: Brent vs WTI
It is no secret that the most important crude oils in the world are the European Brent (extracted by 15 oil fields located in the East Shetland Basin in the North Sea) and the American WTI which is extracted in the US and delivered at the Cushing in Oklahoma. It is well known that the Brent Crude oil has become the global benchmark and it is used to price crude oils worldwide. Although they are extracted in geographically distant locations the chemical composition of WTI and Brent is not exceptionally different because both of them are considered to be “sweet oils” which means that both contain a low concentration of sulphur: 0.37% for the Brent and 0.24% for the WTI. This small introduction, brought to you by HyperVolatility, is necessary to understand that the supply/demand forces driving price fluctuations are dissimilar and the discrepancy is even clearer if we add that the Brent is exported in the whole Europe and worldwide while the WTI does not leave the US.
The Brent/WTI arbitrage (the word arbitrage is a misnomer because we are buying and selling two different asset classes) is a fairly popular trading technique within the energy sector and its aim is to profit from price discrepancies. The strategy is reasonably simple and it consists of contemporarily selling the WTI and buying the Brent (short arb) or selling the Brent and buying the WTI (long arb). Clearly, this is a spread trading technique rather easy to implement and control because both Brent and WTI futures share the same size (1,000 barrels) while the tick value (1 cent per barrel) equals to $ 10 for both contracts.
How does the trade work? Let’s assume that a trader decides to sell WTI and buy Brent futures (short arb). He sells the WTI at $ 100 and buys the Brent at $ 110 and he will make money if the 2 asset classes will move in opposite directions. If the WTI drops to $ 97 while the Brent closes at $ 112 our hypothetical trader would have made a $ 3,000 profit from the WTI and $ 2,000 from the Brent for each contract traded.
What happens if WTI and Brent move in the same direction? The strategy would still be profitable if the price augment in the Brent market outweighs the rise in WTI futures. If the Brent gains $ 3 and the WTI $ 1.5, the trader would make a $ 3,000 profit from the long Brent position but he would lose $ 1,500 on the short WTI contract which implies that the overall profit would be equal to $ 3,000 — $ 1,500 = $ 1,500
As you can see the trade would still show a profit because in our example WTI and Brent experienced different volatilities and consequently their fluctuations were not symmetrical in terms of magnitude (the first moved 3 dollars and the second only $ 1.5). However, should the Brent had moved lower and the WTI higher the short WTI / long Brent position would have lost money.
The chart #1 shows how the most important oils oscillated since 2009 until 2011:
It is evident that until 2011both WTI and Brent were moving symmetrically but for some fundamental reasons, such as global demand and some logistic problems with the WTI, the prices started to diverge and the spread became rather large. On the other hand, the narrowing of the arb from September 2011 onwards is mainly due to an increased demand and to the construction of the Seaway pipeline which facilitates the transportation of the WTI from the Cushing in Oklahoma to Freeport in Texas. Let’s have a look at the WTI/Brent spread now:
The chart #2 shows very clearly that since 2009 until the beginning of 2011 the differential oscillated following a mean reverting process (because it always tended to get back to the 0 line) and it used to fluctuate within fixed boundaries (because it rarely surpassed the $ 2.5 threshold and infrequently remained below the — $2 level for an extended period of time). However, the scenario has quite changed because in 2011 the Brent/WTI spread increased substantially and achieved the $ 25 level. If we go back to the first chart we can immediately understand what caused such a high spread: the Brent price kept increasing while WTI futures prices kept dropping.
How can a trader take advantage of such divergence? When the trade should be triggered?
Buying or selling the oil arb is up to the trader and it depends on fundamental data such as supply/demand forces, industrial productivity, etc but it is possible to identify when the trade could have a higher probability of success. The chart #3 will help us prove our point:
The graph shows the correlation (which fluctuates within -1 and 1) between Brent and WTI since 2009 until the end of the 2011 and its interpretation is straightforward: the higher the correlation, the stronger the relationship between the 2 asset classes. The correlation on average is rather high which means that Brent and WTI tend to experience similar fluctuations, although with different volatilities, but there is a second important characteristic that it is very useful in practical terms: the correlation is mean reverting because it tends to drop and then explode again.
In practical terms, all the time the correlation index drops the relationship between Brent and WTI weakens, hence, the probability of dissimilar fluctuations amplify. Conversely, an increasing correlation would imply the opposite scenario.
We now know that a plunge in the correlation index would increase the probability of maximizing our profits because it would highlight that the relationship between the 2 asset classes is not going to be strong and that the spread will likely expand. However, in real trading conditions we will need specific entry points, some numerical thresholds to look at in order to trigger our trades and the following tables should be a valuable tool for anyone interested in trading the oil arb:
Bear in mind that these are not trading recommendations but merely a guide and the price / correlation levels refer to the period 2009–2011.
The table #1 represents the price distribution of the Brent/WTI spread. The outcome of our research shows that the lowest price achieved by the spread is $ -5.42 (which means that the Brent was lower than the WTI) while the highest point was $ 26.84. The percentage row displays the percentage of observations below the reported price levels. In other words, the 24.97% of total observations were below the $ -0.36, almost 50% of the Brent/WTI spread prices were below the $ 2.28 level while the price fluctuated below the $10.98 threshold in the 74.77% of cases. Now let’s see what the correlation key points are:
On average the correlation is around 0.82 but in the 25% of cases it dropped to 0.62 and it remained lower than 0.91 almost the 80% of the time. The extreme points are -0.35 and 0.99 that have been touched only once.
1) The Brent/WTI spread fluctuated within $ 2 and $ 2.3 most of the time
2) The correlation is usually fairly strong and it frequently oscillates around 0.78 and 0.82
3) In order to have a reliable entry point both price and correlation should be out of their ranges. We should be in a situation where there is an evident mismatch
4) Entry points are signalled by a breakthrough of the aforementioned price and correlation levels because if the arb price is higher than $ 2.3 and the correlation is lower than 0.78 then the probability of success is higher. Needless to say that good opportunities arise also when the arb price is lower than $ 2 dollars and the correlation is higher than $ 0.8
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