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Crude Oil Statistical Arbitrage: Discrepancy In Brent Vs WTI

Summary

Since the midyear low crude prices, prices of Brent and WTI have diverged past their recent historical spread.

Prices have been highly tied to geopolitical developments.

In the event of convergence, investors could profit.

A recent divergence in two of the benchmark global crude oil prices has created a potential opportunity for statistical arbitrage. This comes after a midyear slump that drove per-barrel prices under $50. In the event of convergence of these prices, which history shows is likely, investors could profit by engaging in stat arb.

The benchmark crude oil prices of West Texas Intermediate (WTI) and the North Sea’s Brent have historically traded very closely and highly correlated, usually with no more than a few dollars separating the two on a per-barrel basis. The recent sub-$50 oil slump and subsequent recovery that is now in our midst have seen the prices of these two commodities bifurcate, however. Both began 2017 in the mid-$50’s per barrel, but experienced a sharp decline as OPEC officials scrambled to deal with a persistent global crude oil supply glut. The glut was symptomatic of all-time-low compliance rates among nations that pledged to cut supply in late 2016, combined with surging output from nations exempt (for political reasons or otherwise) from this agreement.

In the first half of this year, the daily average per-barrel price spread between Brent and WTI was about $2.70, with Brent on the higher end. In the second half of the year to date, since the year’s bottom of daily average price, this average daily spread has increased to about $4.40. As the oil recovery continues and prices normalize, this price disparity relative to the historical spread could potentially lend itself to a statistical arbitrage opportunity. This increased spread could be explained by numerous factors. For example, noise resulting from the geopolitical discourse could drive these fluctuations. Statistical arbitrage (also known as “stat arb”) is when an investor has simultaneous long and short positions on two different securities or commodities in order to make a profit from pricing inefficiencies.

With Brent being the higher and West Texas Intermediate being the lower of the two, one could capitalize from this potential price inefficiency by shorting Brent and buying West Texas Intermediate. A price convergence back to around the usual historical spread would likely involve the price per barrel of Brent to drop (justifying the short position) and West Texas Intermediate to rise (justifying the long position).

Though termed “arbitrage,” this maneuver would not be without risk. Any stat arb execution operates under the assumption that prices will revert back to their historical relationship, which could be fallacious with a forward-looking investment. Additionally, the oil price recovery is still underway, and price fluctuations until normalization could make determining appropriate entry and exit points nearly impossible.

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