The Volatile Crude Trading Opportunity is Back

The Volatile Crude Trading Opportunity is Back

There has always been a difference in price between the two major crude blends – WTI and Brent – and traders have often invested in the spread between these two; now the trade is becoming popular once again. To understand the mechanics behind the situation so that we can benefit from them,an examination of the characteristics of the product is in order.

One of the main differences between Brent oil, which is produced in the North Sea vicinity of the Brent oil field, and West Texas Intermediary, the oil characteristically produced in North America, is the former’s higher sulfur content. As a result, Brent usually requires more expensive extraction and refining technologies and it is usually more expensive to produce. In order to be competitive, Brent is there therefore traded at a large discount. Moreover, since it is the major crude to be traded on a global level, Brent serves as price benchmark for over 60% of the world’s crude market.

WTI, being the more attractive product due to its lower sulfur content, should under normal circumstances be more expensive to the user. However, because the USA has always sought to be energy independent,export restrictions prevent WTI from being exported to other countries, except as distillates and other products of the refining process.

The historical spread between the two has usually held at between 8 and 10 US dollars per barrel favoring the Brent blend for nearly the past 5 years, with the rising demand in the US often expanding that to nearly$12. However, the two assets trend to follow one another, and the spread has been known to narrow to nearly zero. Recently, shale production has dented prices slightly, and dropping commodity prices amidst a slowing world economy have contributed to increased competition and the struggle over market share.

But, what has caused major disruptions in the market has been the rising turbulence in many oil producing countries, primarily the Arab Spring and regional volatility that threatens supply. Today, as ISIS, on one hand, and Iran, on the other, edge ever closer towards choking Saudi Arabia’s major maritime outlets, the Obama administration is doing all it can to reach an accord with Iran, which would result in an additional million daily barrels of oil adding to already overfed crude oil reserves and the market ramifications of oversupply.

So much for the fundamental slick; an examination of the technical situation muddies the muddle even more.

Oil is currently consolidating after a rebound from multi-year lows, and that makes directional timing very difficult to determine.Although traders expect the downward trend to resume, the fundamentals are not yet pushing in that direction. Moreover, the geographical volatility is not making predictions any easier.

And yet, an interesting opportunity does present itself. If you can’t play the trend, look at the spread. Clearly, this too widens and narrows; but by focusing our risk on the spread rather than the direction, the situation becomes almost controllable.

Simply open offsetting positions in Brent and WTI when the spread hits the $1.5-$2 region, although between $3.5 and $4 one should be alert, too. A long position in Brent and a short one in WTI should then be closed anywhere between $8 and $10.

This pattern was quite evident during winter, and investors saw relatively swift results. Although not as lucrative as trend trading,careful risk-reward ratio management should prevent the pitfalls of sharp risk reversals, evident in much oil trading recently; and the strategy enables the smart investor to sleep better at night by simply ignoring what is happening in the more combustible regions of the globe.