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By Sumit Roy

After gradually widening through the end of 2012, the spread between the two pre-eminent crude oil benchmarks - Brent and West Texas Intermediate (WTI) - is starting to narrow. Can the gap close further and will WTI ever reestablish itself at parity with Brent? In this article, we take a look at the latest developments in this key oil spread.

Prices For Brent & WTI

Historically, Brent and WTI traded at similar levels. Indeed, the higher-quality WTI often traded at a slight premium to Brent crude. But starting in 2010, the situation changed and Brent began trading at enormous premiums to its U.S. counterpart.

WTI has now traded at a discount to Brent for 29 months and counting, the longest such stretch in history. More importantly, we also see a discount through the entire forward curve up to 2020.

Crude Oil Forward Curve

The culprit is the glut of oil at Cushing, Okla., the delivery point for Nymex light, sweet crude oil contracts. Surging production in Canada's oil sands, and more recently, rapidly escalating output levels in the United States, have saturated the greater Midwest region with crude.

In fact, at 115 million barrels, crude oil inventories in the Midwest are at 78 percent of the net available shell storage capacity, according to Department of Energy data. Only 32 million barrels of capacity remain in the Midwest, most of it in Cushing. Therefore, the extremely wide discounts we see on WTI trapped in the Midwestern system is the market's way of allocating this increasingly scarce storage capacity.

Because the Cushing region is landlocked, it's inaccessible to barges or tankers that might open up opportunities to arbitrage the wide differentials between WTI and other crudes. Somehow, oil from the Midwest must be transported to other regions where it can be more readily marketed. Relief may be on the way.

Just last week, capacity on the Seaway pipeline-which runs through Cushing to the Gulf Coast-was increased from 150 Kbbl/d to 400 Kbbl/d. Capacity is expected to more than double to 850 Kbbl/d by mid-2014. Additionally, the Gulf Coast Pipeline project will extend TransCanada's Keystone Pipeline from Cushing to the Gulf Coast. The line will have capacity of 700 Kbbl/d to 830 Kbbl/d, with a scheduled launch of mid-to-late 2013.

(Incidentally, the Obama administration's decision to reject the proposed Keystone XL pipeline last year, while controversial, had no impact on the Gulf Coast extension, which does not require government approval.)

Clearly, a significant amount of pipeline capacity from Cushing to the Gulf will be coming online over the next year. While the spread between Brent and WTI may remain wide in the short term, the potential for more than 1 million barrels per day of additional takeaway capacity between the GCP and the Seaway pipeline make it likely that the glut of crude in Cushing will be alleviated by 2014.

Currently, 2014-dated WTI futures are trading $9 to $11 below the equivalent Brent contracts. Thus, traders taking the view that the spread will disappear by then have the opportunity to make a handy profit.

One way to initiate such exposure would be through futures, whereby a trader would simultaneously go long one contract, while shorting the other. So, if one believes that the aforementioned pipeline projects will alleviate the Cushing glut, then going long December 2014 WTI futures while simultaneously shorting December 2014 Brent futures would reflect that view.

Investors can also play a potential narrowing of the spread through exchange-traded funds by purchasing a WTI-linked product, such as the United States Oil Fund (NYSEARCA:USO), while simultaneously shorting a Brent-linked product such as the United States Brent Oil Fund (NYSEARCA:BNO).

But as these ETF products invest in front-month futures, investors will have to be mindful of the associated costs of rolling from contract to contract, which could alter the profit potential of any trade.

Source: Investors Can Profit From Decline In WTI - Brent Spread Fueled By Pipelines Changes