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.
Both gravity and sulfur content are dynamic and will fluctuate over time as a given stream or blend of crude oils changes in origin, reservoir depth and quality. Crudes that are low in sulfur are considered “sweet,” while high sulfur crudes are termed “sour.” High gravities (>39) are considered light while low gravities (<25) are considered heavy; midrange are considered intermediate or medium (see “Inside crude,” below).
The sulfur content and gravities of crude oil imply a price relationship similar to that of fuel oil. Coupled with this inherent implied value, relative premiums and discounts also are influenced by regional supply and demand factors, product seasonality, refinery margins and run rates, geopolitics, tonnage capacity and many other variables.
This year has seen unprecedented uncertainty and turmoil in the global crude oil markets. Libya declared force majeure from its Es Sider (As Sidr), Ras Lanuf, Zueitina and El Brega ports covering the country’s crude and product exports. Crude exports are down roughly 90% from 2011 levels according to Reuters analysis and labor issues continue to affect one of the most important grades entering the Mediterranean. On Aug. 26, the Libyan military declared they will “strike and destroy…any oil tanker” attempting to load cargo that was not under contractual agreement with the national oil company.
The military “coup” in Egypt has brought the Suez Canal into play. While traffic flows through the canal have been uninhibited so far, the prospect remains that the canal may close temporarily or indefinitely. Closing the canal would alter tanker trade routes, requiring tankers to take the longer West-bound route around the Cape of Good Hope, thus extending their time in transit and decreasing available capacity on the market. The canal has closed before and is within the realm of closing again.
Tensions in Syria and by proxy, Iran, could potentially bring the Strait of Hormuz back into flux as well. History has proven Iran both capable and willing to attack commercial freight and mine traffic lanes in the Persian Gulf and the extremely vulnerable and narrow Strait of Hormuz.
Moving beyond hypotheticals, medium sour Kirkuk flow into the Mediterranean via the Kirkuk-Ceyhan pipeline continues to be the victim of constant bombing and sabotage by local militants. There have been seven attacks on the pipeline to date in 2013.
Middle East and North African crude grades likely will remain constrained going into the end of the year.
In the North and Baltic seas, medium sour Russian Urals continues to flow through Primorsk, Ust-Luga and Novorossiysk. Primorsk likely will see decreasing export volumes as the “ice premium” begins to set in, making lifting from the port less attractive than its southern neighbor Ust-Luga. Through the summer and fall however, the former Soviet Union is taking full advantage of the current fear in the market and has increased export volumes in September from Primorsk and Ust-Luga by 25% and 32% over August loading programs, respectively. Comparatively, September exports from the Baltic port of Novorossiysk are up only 9.1% from August, according to Bloomberg data.
The continued loss of Libyan grades on the market has caused medium sour and light sweet supplies in the Mediterranean to tighten moving into the fourth quarter. The temporary disruption opened the arbitrage of North Sea Urals cargoes to make their way into the Mediterranean for French and Italian delivery (see “Here’s the upside,” below).
Urals into the Mediterranean via Novorossiysk is at further risk according to recent statements from Rosneft. The Russian state-owned giant has hinted that they are open to reversing the Baku-Novorossiysk pipeline and leaving the crude in Azerbaijan for refining. Azerbaijan’s state energy company, SOCAR, has been in talks with Rosneft to reverse the flow of oil five million tons per year, roughly 38 million barrels, allowing SOCAR to refine the crude domestically. According to August press reports, Russian pipeline monopoly Transneft may not approve the deal; however, Urals supply, particularly to the Mediterranean, remains uncertain.
Trading opportunities in the global crude oil and product markets should continue as volatility on the world’s crude oils rises from yearly lows into the balance of the 2013.
The loss of Libya’s light sweet has caused differentials of other light sweets such as Azerbaijan’s Azeri Light, Nigeria’s Qua Iboe and Bonny Light to trade up relative to Brent (see “Crude continued higher?” below). The continued disruption in light sweet supply has weighed heavily on margins as the products largely have not yet followed suit. Without a rise in margins, Platts suggests the differentials will not necessarily fall; however, they should not rise much further. Refiners in the ARA complex are large buyers of Libyan crude and these issues will bring their weight to bear on the Northwest Europe product markets in the coming months.
We anticipate short-term volatility to rise off multi-month lows going into the fourth quarter. The issues surrounding Kirkuk, Urals and Es Sider will continue to have tertiary effects on other crudes and products at hubs around the globe. Additionally, geopolitical posturing by major crude exporters in the face of the Syrian conflict only will compound global volatility as the U.N. Security Council is unlikely to approve international intervention following the recent sarin gas attacks (see “Got volatility?” below).
The fourth quarter is likely to be choppy. Buckle up.
Jason S. Williams, ERP, is an over-the-counter commodity broker specializing in the global energy markets for Coquest in Dallas, Texas. Currently he is pursuing his master’s degree in shipping and logistics from Middlesex University’s Lloyds Maritime Academy. You can reach him at firstname.lastname@example.org