One of the most widely traded and followed spreads in the oil complex is the WTI/Brent spread. West Texas Intermediate (WTI) crude oil is the U.S.-based benchmark for 40% to 50% of the world’s crude oil. Brent crude oil is made up of several classes of crude found in the North Sea. Brent is the European benchmark for 50% to 60% of the world’s crude oil. Both of these crude oils trade as futures on the New York Mercantile Exchange (Nymex), now CME Group, and the Intercontinental Exchange (ICE). They are both light, low sulfur crudes with WTI slightly more favorable for gasoline production while Brent Blend favors diesel production.
The spread is affected by several drivers, but the single most compelling driver is the level of crude oil inventories in the United States PADD 2 (Cushing, Okla. is a subset of PADD 2 and the Nymex delivery location for WTI) or midwest area. As shown in “Padding your margin,” when crude oil inventories in PADD 2 are increasing, the WTI/Brent spread normally narrows, as has been the case over the last six months. When inventories are declining, the spread normally will widen, as it did in the second and third quarters of 2007. These are both very pronounced and long-term moves, but when looking at the chart closely the relationship also exists even during periods when inventories increase or decrease by a much smaller amount than the large movements previously mentioned. From both a financial trading and physical crude oil pricing perspective, the optimum trade has been to be short WTI/long Brent for the last six months or so. But that strategy seems to have run its course.
During the last two weeks of February, crude oil inventories have started to decline in the PADD 2 region of the United States as the widely discussed OPEC cuts slowly begin to eat away at the crude oil overhang. In February, OPEC produced and exported about 4.2 million barrels per day less oil than it did in September 2008, when it began to cut production. It is slowly getting ahead of the demand/decline curve resulting from the faltering global economy. By the time you read this article, OPEC most likely will have announced an additional cut at its March 15 meeting. This should result in further declines in PADD 2 inventories and thus a change in the direction of the WTI/Brent spread.
Over the last few weeks, the WTI/Brent spread seems to have bottomed and has now been in an evolving uptrend. The spread has broken key resistance and, as discussed above, this direction is supported by the slowly declining inventories in PADD 2. With refinery runs likely to increase slowly as U.S. refiners prepare for the beginning of the summer gasoline driving season, crude oil inventories in PADD 2 may decline even further, especially if OPEC holds the line and keeps production at the current constrained level. The spread has more room to widen and if all of the analysis presented holds, WTI should once again return to trading at a more natural premium to Brent.
To take advantage of the changing conditions, we suggest looking at the May ‘09 WTI/Brent spread (traded on both the Nymex and ICE). We chose the May spread to give the trade time to evolve. The May Brent contract expires first on April 15 with considerably more time for the ongoing OPEC cuts to further affect inventories. You should use tight trailing stops and watch the weekly Energy Information Administration inventories, which are released each Wednesday morning at 10:30 EST and can be found on its Web site.
For those on the physical side of the business, most physical crude oils around the world are priced either on a WTI or Brent basis and thus the direction of this spread is extremely important for physical asset traders. If the WTI/Brent spread is in a widening uptrend (as it is now starting to be) buyers should look to benchmark all physical purchases on a Brent basis. If that is not possible and the physical purchase has to be done on a WTI basis, during the current uptrend the buyer of the physical crude should shift the pricing basis from WTI to Brent by selling the WTI/Brent spread. The WTI side would be negated and in essence the physical purchase would now be based on Brent, which should lag the WTI price under the scenario presented.
Dominick A. Chirichella is a founding partner of the Energy Management Institute and author of Energy Market Analysis. For a free trial of the daily newsletter please email Dominick at firstname.lastname@example.org .