How to Trade on Crude Oil Spreads
One of the richest men in his time, petrol-industrialist J. Paul Getty is believed to have said, “Oil is like a wild animal. Whoever captures it has it.” Even today, over half a century later, crude oil plays a pivotal role in economics and is as wild an animal as ever.
The price of oil fluctuates to reflect swings in demand and supply and this volatility is aided along by speculators, cartels and, quite importantly, geo-political developments.
So, what would you say if we tell you that there’s a way to ride this wild animal with a fair amount of safety?
It’s a technique called betting on spreads.
But before we explain how it works, you need to know about the dynamics in the oil market. If you already do, you can skip ahead to What are spreads?
The Two Most Popularly Traded Crude Oils
There are various grades of oil but the most popular traded grades amongst these are the Brent North Sea Crude (usually referred to as Brent Crude) and West Texas Intermediate (largely known as WTI).
Brent Crude gets its name from the fact that it is produced in the Brent oil fields and other sites in the North Sea. It is referred to as ‘sweet’ crude as it has fairly low sulphur content, which makes it relatively easy to refine into various products like diesel fuels. Roughly two-thirds of the world’s crude oil prices are benchmarked to Brent, especially crude in Africa, Europe and the Middle Eastern.
WTI, the other most popularly traded variety of crude, has become the benchmark for North America. With even lower sulphur content than Brent, WTI is a better grade of crude oil for the production of gasoline.
Some parts of the world, specifically Asian countries, benchmark the value of their crude to both Brent and WTI.
Now, there is usually a difference between the prices of these two benchmarks. Although superior in quality, WTI in recent times has been trading at lower rates than Brent for political and logistical reasons.
And the difference between the price of these two heavyweights keeps fluctuating. In a single year – 2011, the difference in the price shot from almost zero at the beginning of the year, to Brent being USD 25 more expensive than WTI towards late 2011.
This brings us to the concept of ‘crude oil spreads’ and how you can trade on them.
What are spreads?
A spread involves the simultaneous purchase of one commodity and sale of the same or a similar commodity. Spread positions tend to be less risky than outright long (buy) or short (sell) commodity positions.
There are various types of Spreads:
1. Calendar Spreads – This involves buying and selling different contract months within the same commodity. For example, a trader can buy May soybeans and sell November soybeans. As you may have figured, this type of spread is usually leveraged to gain from the seasonality of commodities.
2. Inter-market Spread – This type of futures spread involves buying and selling different but correlated commodities. So for instance, a trader could buy silver and sell gold when these metals are expected to move inversely to each other.
3. Inter-Exchange Spread – This spread involves the simultaneous purchase and sale of the same or similar underlying commodity that trades on different exchanges. In the Indian context, Brent and WTI Crude is one of the best examples for Interexchange Commodity spread as WTI Crude trades on MCX and Brent trades on the NSE.
The Spread between Brent and WTI
Now as we mentioned before, the difference between the Brent Crude Oil Spot Price and WTI Crude Oil Spot Price keeps fluctuating.
Put very simply, this difference is the Brent to WTI Spread.
Over the past two years the Brent to WTI spreads have been moving in a band of 11 to 2.5 levels. On two occasions, the spread has bottomed out at 2.5 and marched upwards after towards 10 to 11 approximately.
There are various factors that drive this movement. We examine some of these below…
2011-2014: The Brent-WTI spread widened due to supply disruptions as the Arab Spring toppled Libya’s government. Syria and Yemen, which are relatively smaller producers, also saw their production plunge as they collapsed into civil wars.
2015-2017: The gap between the two benchmarks narrowed again during the supply glut in 2015 and 2016. From 2017 it began to widen again, this time largely for reasons related to the boom in US shale oil production, Middle East Tensions (US sanctions on Iran and Venezuela) and OPEC -production cuts.
Mar to July 2018: A sharp rise in Brent prices widened its premium over WTI prices to approximately $11.37 (in the 1st week of July) mainly due to good economic activity around the globe. However, the spread narrowed down to approximately $2 .61 levels on 20th July as the US imposed tariffs on China.
20th July to Oct 2018: The premium of Brent prices to WTI prices widened to as much as around $11.50, the highest in more than four years. Cheaper WTI was the result of rising US production, which rose more 11.50 million barrels per/day. However, after that, the Brent-WTI Spread narrowed to $6.50 in December 2018, mainly due to a US waiver of sanctions on some countries, like China, Japan, Korea and India, that were importing Iranian oil.
2019: Spreads consolidated in the range of $8.50 to $11.70 levels. After that, the Brent to WTI spread narrowed and made a low of $2.80 to $3 levels by 20th Aug 2019 due to a slowdown in the global economy. However, after that spread widened due to geopolitical tensions in the Middle East and a pick-up in global economic activity
Year-end 2019: Currently the spread is trading at $5 levels and is expected to move towards $8 to $10 levels in the coming months.
So, what triggers movements in the Brent/WTI Spreads?
In a nutshell, the Brent-WTI spread widens due to
- Geopolitics tensions in the Middle East (Brent price is very sensitive to Geo-political reasons)
- Lower production from Middle East countries or OPEC countries
- Higher Shale oil production in the US
- Global demand increased for Crude oil.
When these factors reverse, the Brent-WTI spread starts to narrow in.
NSE Brent and MCX WTI Crude Spreads offer opportunities
The fluctuation in international crude oil prices is mirrored by the prices of crude on the domestic exchanges. The spread between NSE Brent and MCX WTI Crude provides good spread trading opportunities.
Source: NSE, MCX, Ticker plant, Ventura Securities ltd
A caution, however, is that NSE Brent futures currently suffer from low volumes and lack of liquidity at times. Nevertheless, we notice that Bid-Ask price spreads are low in NSE Brent futures. More importantly, as institutional players such as mutual funds and commodity index funds enter this segment, the volume can be expected to increase.
Setting up a Brent-WTI Spread Strategy
To put it very simply, whenever the international Brent-WTI spread falls to levels of 2.5 to 3, it can be expected to widen. Accordingly, Buying Brent and Selling WTI will deliver gains. Conversely, whenever the spread touches 10 to 11, it can be expected to narrow. At those levels, Selling Brent and Buying WTI is the strategy to implement.
Let’s look at two examples where you could benefit from trading on the Brent-WTI spread – one in which the spread is rising and the other where the spread is falling.
Example 1: Falling Brent-WTI Crude Spread
Let’s say on 1st May 2019, you sold Brent futures (lot size 100) on the NSE and bought WTI Crude futures (lot size 100) on the MCX, when the Spread was 623.
Your total Margin requirement would be Rs 80,000.
Then, on 1st August 2019, when the spread fell to 256, you reverse the transaction by selling WTI Crude and buying Brent futures.
You would have made a profit of Rs 36,700 on the 58.9% fall in the spread. That translates into an ROI of 45.9%.
Example 2: Rising Brent-WTI Crude Spread
Now let’s look at another example where the spread rises.
Suppose on 21st August 2019, when the Brent-WTI Crude Spread is 301, you buy Brent futures (lot size 100) on NSE and sell WTI Crude futures (lot size 100) on MCX.
Now you waited till the spread rose to 430 on 31st October and reversed your transaction by selling Brent futures and buying WTI Crude futures.
You would have made a profit of Rs 12,900 on the 42.9% rise in the spread. That translates into an ROI of 16.1%.
Advantages of trading on the Brent-WTI Spread
- The Brent-WTI Spread is one of the most widely traded spreads in the commodity markets. As a result, information is easily available on it.
- In India, the transaction cost is relatively low at around Rs 150 (both side).
- Trading a spread between Brent and WTI is relatively low risk.
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We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.
What should be the range of spread according to todays price of oil