Here’s Why, And What You Can Do to Profit From It
If you are somebody who trades the energy markets, or even follows them closely, you will probably be aware that terms like “oil price” or “the price of oil” are actually quite misleading. There is not one oil price, there are many of them. The price that producers fetch for a barrel of oil depends on what type of oil their well produces and where in the world it is produced.
For most traders, though, there are essentially two prices that matter, Brent and WTI, and there are reasons to believe that the difference between them, the spread, is about to widen.
What Are Brent and WTI?
Both Brent and WTI are benchmark prices for crude. Brent is that for oil produced in the North Sea, the main production area in Europe, while WTI stands for West Texas Intermediate and is the benchmark for oil produced in the U.S. Both are relatively “light and sweet”, making them good for refining into gasoline. There are plenty of other grades and benchmarks too, most notably the OPEC Basket, but for traders, Brent is taken to represent ex-U.S. global pricing, while WTI represents the domestic U.S. market.
Why Is There A Spread?
Oil is a global market to some extent, so much of the time, the two main benchmarks move in unison. Sometimes, though, they diverge, or at least move at different paces. That typically comes when one area is influenced by something that doesn’t impact the other as much, if at all.
The classic example of that would be disruption in the Middle East. In that case, the OPEC basket would move the most, with Brent pretty close behind due to geographical proximity and the fact that they often compete with each other. U.S. pricing, on the other hand, is less influenced by those events, as most of the oil produced here is consumed here.
A similar effect might happen the other way round if a hurricane or some other natural disaster restricted supply or impacted demand in America. In that case, WTI would move further than Brent on the news.
Why is the Spread About to Move?
No, I don’t have a crystal ball that enables me to foresee the next crisis in the Middle East, nor am I an expert weather forecaster, anticipating a hurricane hitting the Louisiana or Texas coastline. Those things would have an effect on supply, but supply is not the issue here.
What we are seeing now is demand, and expectations for future demand, in the two regions starting to diverge.
The U.S. is, it seems, in a full-blown second wave of Covid-19.
The rural and southern states that escaped the worst of the pandemic initially mostly decided to re-open their economies early because of that, but are now seeing surges in cases, hospitalizations, and even deaths. The path to reversing that is pretty clear. It is the path followed by the likes of Connecticut, New York, and New Jersey that, so far, haven’t seen a second spike… and that means shutting back down and staying shut for a while.
That may not be easy in those states and, politically, may even prove impossible, but if cases continue to rise there will be an expectation of that happening. That expectation for weaker oil demand will come just as most of Europe and Asia are regaining their footing and demand in those markets is picking up.
With supply restricted in both cases, due to OPEC cuts in one case and well closures in response to the price collapse in the first half of this year in the other, that differentiation in demand and expectations for demand will be driving relative pricing.
Brent, therefore, looks set to outperform WTI significantly over the next few weeks, or maybe even months.
The Technical Read
The longer-term chart for the spread is distorted by what happened in April, when a storage crunch met massive oversupply as a WTI futures contract expired, forcing U.S. crude into negative territory. However, if you look at a shorter-term chart you can see that the spread has been fairly steady for a while now, but we are seeing the beginnings of a move up.
A word of warning, though. Don’t read too much into the chart for the spread. It is traded to some extent, but it is mainly a product of two markets moving independently, so really has no distinct levels of even support or resistance. More complex signals, therefore, are unreliable enough to be useless. Still, you can see from the chart above that the spread is beginning to widen, and that is a trend that can continue.
How to Play It
The idea here is a paired trade, simultaneously going long Brent and short WTI. That way, only the spread between the two will impact your outcome, whether oil in general moves up, down, or sideways.
Not that long ago, that would have been easy. You would simply buy a leveraged Bear WTI ETF and a leveraged Bull Brent ETF. However, the previously mentioned collapse broke those funds, so now you will have to use futures or options or at least involve a short position. You could, for example buy the Brent Oil ETF (BNO), while selling short the U.S. version, USO.
However you do it, though, positioning for a widening spread as the differences between the current state of the coronavirus in the U.S. and elsewhere become more pronounced makes sense. It is hedged by nature so unlikely to result in big losses but could provide a nice profit if economic conditions in the U.S. turn down again.