Trading The End Of The Brent-WTI Spread

Includes: BNO, UGA, USO
by: Kenneth D. Worth

It was recently announced that one of the major pipelines flowing into Cushing, Oklahoma, would be reversing direction due to a change in ownership. One of the previous owners, ConocoPhillips, is a major refiner in the Cushing area and was benefitting from the glut of oil at the trading hub. 150,000 barrels per day flowing into Cushing will be replaced by 150,000 (and later up to 400,000 barrels) flowing , a net loss of oil to Cushing of between 300,000 and 550,000 barrels per day beginning in the second quarter of 2012.

Beyond that, the new Keystone pipeline project will connect the Canadian tar sands with Gulf Coast refineries by 2013, further reducing the likelihood of any pricing disparity between Cushing and global markets.

Clearly, this information was available to some market participants in recent weeks, and the spread of Brent crude oil over WTI has narrowed from over $20 to around $9.50 per barrel. Since the historical spread between Brent and WTI is typically a $1 to $3 premium on WTI, there is still some opportunity for traders to take advantage of a normalization of WTI prices.

Long positions in USO can be hedged by short positions in BNO or UGA (ETFs holding Brent, crude oil and unleaded gasoline, respectively). If shares in these fairly illiquid securities are not available to borrow, short positions in big integrated oil companies can substitute as a reasonable proxy for a short position on global oil prices.

Alternatively, naked long positions in USO offer a solid 10% return over six months, plus or minus any change in global oil prices during that time. The previously harmful steep contango in oil prices has switched to a mild backwardation, benefitting crude oil ETFs such as USO, which must roll its futures contracts each month.

Furthermore, the vehicle sales numbers coming out of China this fall have been fairly solid. Chinese car dealerships should sell 18 million vehicles by the end of 2011, up slightly over 2010. October 2011 sales have come in at 1.52 million cars and trucks. While there has been some concern that these numbers are not up 15% to 30% over the previous year (as in 2009 and 2010), we are still talking about 18 million new cars on the road here. That's a lot of new demand for refined product.

Even if there is a mild recession in Europe and the US this spring, another roughly 12 million vehicles will hit the road in the developing world over the next six months. The few hundred thousand jobs lost in Europe, the US and Japan during a mild recession in 2012 wouldn't seem enough to offset this new global demand.

The key, of course, is supply. Saudi Arabia recently ramped up production to around 9.8 million bpd in June 2011. Saudi oil production fell back slightly in July, September and October to around 9.6 mbpd. The 9.8 mbpd area tests the upper limits of Saudi production between 1980 and 2011. Indeed, Saudi Arabia has not produced more than 9.8 mbpd of oil in nearly 30 years. Are those tired old fields still up to the task? Who knows?

And if additional supply is not forthcoming, what will fuel those 12 million shiny new vehicles hitting the Developing World's roads this Spring?

At the very least, long positions in USO give you a free 10% to play with as we all find out what will happen in the global oil markets in Spring 2012.

Disclosure: I am long USO.