Playing The Great Divide Between Brent And WTI Crude Oil

Includes: BNO, HFC, TSO, USO, VLO
by: Paulo Santos

Crude (NYSEARCA:USO) has been, for many years, a worldwide market. Yes, there were grades of oil that had different prices, but those different prices had more to do with technical qualities of the oil, it being sour or sweeter, heavier or lighter, than with where it traded.

In such a market, the WTI (West Texas Intermediate) that traded in New York had a price that was always close to the Brent traded in London. Indeed, nothing else was to be expected, since you could even physically settle the WTI contracts by delivering Brent.

That all changed in 2011. And the change happened mostly on a technicality. The WTI futures contracts are physically delivered in Cushing, Oklahoma, and with most pipelines flowing in, an increase in production from shale, and a slow decrease in distillate consumption, it happened that Cushing got flooded with crude inventories.

click to enlarge

The unthinkable happened. WTI prices disconnected from Brent, and Brent soared much higher than WTI. At the same time, Brent turned into the true worldwide benchmark, the "real" price for crude. The chart below chronicles the ratio between the two crudes, mostly pegged to 1, until this phenomenon took place.

Recent Events

After the ratio between Brent and WTI took a plunge at the tail end of 2011, it again shoot higher during January and February 2012. This time the real culprit, however, doesn't seem to be the Cushing inventories. More likely, this new widening is the result of changes in the DJ-UBS index, where a rebalancing of the weights towards Brent and away from WTI meant that 90000 contracts on WTI had to be sold, and 55000 contracts on Brent had to be bought. A further rebalancing of the S&P GSCI also exacerbated the effect.

A possible trade

Given than this time the reason for the spread widening between Brent and WTI seems more transitory, and also taking into account that the Seaway pipeline should start delivering crude oil from Cushing to the US Gulf Coast in June, at a rate of 150000 bpd, it seems probable that this huge gap has 4-5 months to last, at most.

One possible way to take advantage of the situation, would be to short May WTI crude, presently at $99.64/barrel, and go long June WTI crude ($100.21) or July WTI crude ($100.65).

One other would be to short July Brent ($114.77) and go long July WTI ($100.65).

Also important

Given the wide divide, the crack spread as calculated using WTI will seem unnaturally tasty. This might drive buyers into refiners such as Valero (NYSE:VLO), Tesoro (NYSE:TSO), Western Refining (WSN) and HollyFrontier Corporation (NYSE:HFC). It would seem that the transitory nature of the situation, together with structurally lower fuel consumption and, predictably, structurally lower crack spreads, would advise against falling for this temporary phenomenon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.