From the October 2013 issue of Futures Magazine • Subscribe!

Got volatility? Use OTC markets as a guide to arbitrage

If the volatility of global markets year-to-date is any indication of how the year will come to a close, the predominant themes going into 2014 will continue to be turmoil, fear and uncertainty. Astute traders take advantage of the heightened volatility by seeking arbitrage opportunities in the spot and forward markets around the globe. Opportunities come in the form of time, location or grade spreads.

A time spread is a simple contango trade whereby the difference (spread) between front month and back month futures is above the cost of carry (storage, insurance, ancillary). One of the most notable time spreads occurred in the steep contango of the West Texas Intermediate (WTI) market at the end of 2007 and early 2008. Participants of this trade were able to store WTI, Brent and other grades in offshore floating storage, evidenced by the parabolic change in rates for Very Large Crude Carriers (VLCCs) and other available tonnage at the time (prior to their subsequent 90+% collapse).  

The rates for VLCCs eventually caught up to the spreads; the arbitrage window closed and with it the demand for freight. Keeping an eye on freight rates at the various crude and product hubs can give you an idea as to how far contango spreads can blow out and, perhaps more importantly, in which direction arbitrage flows are moving.  

Locational arbitrage is very prevalent in the physical trading world. Raw crude, refined products, coal, metals, grains or any other commodity are transported from markets with abundant supply to markets in deficit. One recent location arbitrage occurred in the global high-sulfur fuel oil (HSFO) markets when large physical trading firms purchased fuel oil in the Antwerp-Rotterdam-Amsterdam (ARA) complex and shipped it to the Singapore market, which was experiencing increased demand at the time. 

The ARA-Singapore HSFO arbitrage caused dislocations that in turn created other opportunities for those who were watching. The increased demand for HSFO in ARA sent the price premium to better quality, low sulfur fuel oil (LSFO) in other hubs around the globe. The LSFO market in New York specifically was suffering from oversupply and lackluster demand, a combination never bullish for prices. The LS/HS spread between New York and ARA is an example of a grade arbitrage where the underlying qualities of the product imply a price relationship than can become distorted because of localized supply and demand factors.  

Crude oils typically are defined by  gravity, measuring density and sulfur content, an element that decreases the value of crude oil because of the increased cost of removing it. The gravities of WTI and Brent are 39-40 and 38, respectively. The sulfur content of WTI and Brent are 0.24% and 0.37%, respectively.  

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