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A few years ago, most retail trading was concentrated in shares and currencies. Commodities and precious metals like oil or gold were for experienced and professional traders with large portfolios. Most of the action in the commodities markets was carried through futures exchanges, and trading was in large lots.
Nowadays things are changed. Commodities are traded everywhere and spread betting traders don’t miss a chance to have some oil lubricating their portfolios. Trading occurs in small fractions and a spread better can place trades of just 50p per point at Finspreads or City Index.
Spread betting providers usually offer two flavours of oil to trade on: Brent Crude and WTI Crude or Light Sweet. There are other types of oil but those two are the most important and the ones you are most likely to find inside spread betting.
Brent Crude comes from the North Sea and is a blend of several types of crude from the region. It is responsible for something near 70 or 75% of all oil trades around the World. Nevertheless in the US, WTI is used as reference instead, being cited in the news, TV, and all information sites.
WTI stands for West Texas Intermediate. This is high quality oil with very small quantities of sulphur, making it sweeter. That is why it is also known as light sweet oil.
The difference in quality makes WTI stand out but it does not mean WTI is more expensive. In fact, at the time of writing, WTI is cheaper than Brent. The reason is because quality is just one of the items that are accounted for when the price forms. There are many other variables to account for. Historically they have prices that on average don’t differ much from each other and when the spread widens, it tends to revert back with time.
Spread betters can trade Brent Crude, WTI Crude, and the difference between the two. One traditional market in which speculators like to trade is the Brent-WTI spread. That is basically the difference in price between the two: Brent Crude price less WTI price. It is similar to being long the Brent and short the WTI. Because this spread tends to zero, traders like to place trades when it widens too much or when they believe there are reasons for the price of one type of oil to move quicker than the other.
The level of economic activity and, in particular, future prospects for growth are main drivers for oil prices. If the world economy is set to expand quickly then more oil will be needed to produce and thus the oil price is pressured up.
Regional Differences in the Oil Market
There are several factors influencing oil prices and that may account differently for each type of oil and thus to change the Brent-WTI spread. Regional supply, disruptions in supply and natural disasters all affect unequally the two types of oil. Hurricanes affecting the Gulf coast usually tend to elevate WTI price. They cause disruptions in the regions and led to price increases. Regional demand is also key for prices. WTI is more often seen inside the US while Brent more in Europe and in the developing World. If GDP growth in US is better than Europe in general, WTI may increase faster than Brent. When China is growing faster, maybe Crude can be pressed higher.
Politics affects the economy and thus the oil market. This year we assisted to instability in the MENA region. Problems in Libya, Egypt, Saudi Arabia, and many others, led to some disruptions and to expectations of future disruptions that weighted more on Brent than on WTI.
Pipelines and the general infrastructure to conduct oil to the final client or to refineries are also of crucial importance. In the US there are several pipelines connecting the Gulf Coast up to Canada and to conduct oil around the country. This year there was an inversion of oil direction inside the pipeline infrastructure that resulted in an accumulation of oil at Cushing, Oklahoma, pressing WTI price down that led to a record Brent-WTI spread.
In order to know the direction the Brent-WTI spread will take, a trader needs to evaluate all the factors that may create regional differences and change the demand-supply equilibrium differently for both kinds of oil.
Historical Relation Between Brent and WTI
It is now time to have a look at some data to better understand the relation between the two types of oil.
The following table shows correlations, price changes and the spread for Brent and WTI for the period between 2005 and 2011. The dataset ranges from 20th March 2005 and 20th December 2011. This way, data for 2005 and 2011 does not include the full year.
The correlation between Brent and WTI is high although variable across time. If we look at annual price changes we clearly see that when the price changes in one direction for Crude then it is expected that the price for WTI changes in the same direction and with similar strength and vice versa. Regarding the Brent-WTI spread, it is less than 2.00 on average but this year it widened to an average of 15.44.
The above chart shows that Brent and WTI move very closely but Brent jumped a little more in 2011 creating some kind of a gap between the two. The chart below shows that the spread touched near 30 this year but started decreasing since that point and currently sits below 10.
Start Trading the Brent – WTI Spread
Now that we have identified the main drivers for price in the oil markets and after studying the relation between Brent and WTI, it is time to use the information and knowledge to place spread trades.
As we have learned, you should have in mind that: 1) the spread depends on the evolution of each oil market separately, and there are several regional factors that affect it as we have seen, and 2) the spread tends to revert back to near zero after widening.
After studying the market, it’s time to place the trades. Capital Spreads, for example, allows you to trade directly on the Brent-WTI spread. Others that don’t have such a market still allow you to do the same. Just stake the same amounts on each oil market but in opposite directions and you will get the same position as you would with a spread market. It’s that simple. Nevertheless, there some disadvantages deriving from the simulated position: it will require you a larger margin requirement, because the system will not offset the risks of the long with the short position; it will cost you more in terms of spreads; it will require more attention, because you will need to monitor two positions instead of a single one; it will require changes in stop levels, because you can’t set a stop for the whole portfolio losses but just for each product.
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