How not to speculate on the WTI and Brent oil spread

In crude oil price, there is an ongoing rise in the gap between WTI and Brent oil spot. An investor should watch out for the pitfalls when trying to profit from this spread. I will present here a couple of these pitfalls one should avoid.

In the last several months Brent crude oil price (spot) has picked up and increased more than WTI spot price. As an example, as of January 28th the spread between Brent and WTI was 10.32 USD/b.

Some analysts consider that there are ways in which one could profit from this spread by using other indexes to try and predict the direction of this gap.

Brent oil originates from the North Sea, and as such is mostly exported to Europe, while WTI oil is based in Texas and southern Oklahoma, i.e. its price pertaining to the North America crude oil market.

Thus, it makes sense that there will be competing theories on how this spread is calculated, and, in turn, how to profit from it by examining the variables affecting this spread.

The main variables are, among others, the crude oil stocks in US, the Euro/USD rate, the differences in the consumption of oil between Europe and US, the growth rates of these two regions etc.

Let’s examine a couple of these variables and see if they are related to this spread of Brent oil minus WTI oil prices.

See below the graph of the monthly average changes of Brent oil minus WTI oil prices between the years 1998 and 2010.

Crude oil price, gap between wti and brent 1998-2010

The graph shows that up to 2006 for most of the time WTI was higher than Brent crude oil price.

Since 2006 and even more so in 2007, the gap switched and Brent oil price was higher than WTI crude oil price, in which the peak came in February 2009 with an average gap of 4.23$/b.

There could be some macroeconomic changes affecting this spread and recent years, such as the changes in Euro/USD. Let’s check it out:

Crude oil price wti to brent ratio and EURO USD 1999-2010 The graph above shows the yearly changes (1999-2010) in EURO/USD and the ratio of WTI/Brent (in percentages, instead of usd/b).

I changed the view from spread in $/b (i.e. Brent minus WTI ) to ratio (i.e. WTI/Brent) because the latter seem to have a better correlation to the Euro/usd index.

The graph doesn’t seem to provide much information as to any trend or relation between the two sets. The linear correlation, however, of these two data sets present a strong positive correlation of 0.57 between the yearly percent change of the WTI/Brent ratio and Euro/USD.

This finding, however, isn’t what we need to make us rich in the short run…this finding might prove valuable for long term investing.

Therefore we need to examine the monthly basis:

The graph below shows the monthly changes in EURO/USD and the ratio of WTI/Brent during 2010.

Crude oil price wti to brent ratio and EURO USD 2010

Again, we need to check the correlations between the two:

The chart below shows the correlation for the years 1999-2010 between the two sets (remember on a monthly basis).

Correlation of EURO USD to Crude oil Price Brent-WTI ratio 1999-2010

The chart shows that there is no consistent correlation between crude oil price WTI/Brent ratio and the Euro/USD rate.

Therefore, it seems hard to use the Euro/USD (which is also an unknown) to predict the changes in the spread between Brent oil and WTI oil prices.

Let’s move on to crude oil stocks in the US and it effect on the spread. The logic behind this effect is that changes in petroleum stocks present changes in supply and demand for oil, which could influence the WTI crude oil price and consequentially the spread.

The graph below shows the oil stocks during 2010 and the ratio of WTI/Brent.

Crude oil price, wti brent RATIO AND US crude oil stocks 1999-2010

When examining the linear correlation for the entire period (on a yearly scale) there is some negative correlation of -0.38. When examining, however, the monthly scale there is, again, a much smaller correlation of 0.059% for the entire period, with inconsistent correlation, e.g. in 2010 a -0.26 correlation while in 2009 it is 0.18.

In conclusion, there is little evidence to support using any of the major commonly known indexes such as Euro/USD to predict the changes in the spread between Brent oil and WTI oil prices. Some of these indexes could affect the spread, but they are very volatile and their relation to the gap isn’t necessarily linear nor is it consistent so an investor could rely on it.

For further reading (in this site):

In other sites:

7 comments for “How not to speculate on the WTI and Brent oil spread

  1. Pingback: WTI - Brent Spread - First Enercast Financial
  2. Pavan Kumar
    February 17, 2011 at 2:24 pm

    The article is very informative, and i would like add few more points :
    If we see the spread between the two benchmarks (brent-wti)as on 17th feb 2011 its above 18$.
    This is because of Egypt geopolitical issue.
    The reason why WTI cant match Brent due to high crude stocks in US
    Strong dollar also one more reason why WTI not matching to Brent.
    If we see OPEC basket crude price is at 92 level .

    pavan_va99@yahoo.co.in

  3. Pavan Kumar
    February 17, 2011 at 2:25 pm

    The article is very informative, and i would like add few more points :
    If we see the spread between the two benchmarks (brent-wti)as on 17th feb 2011 its above 18$.
    This is because of Egypt geopolitical issue.
    The reason why WTI cant match Brent due to high crude stocks in US
    Strong dollar also one more reason why WTI not matching to Brent.
    If we see OPEC basket crude price is at 92 level .

  4. admin
    February 17, 2011 at 9:38 pm

    Hi Pavan,

    I agree with you that there are additional factors, some of which you have pointed out. You can see for further discussion on this issue in related post I recently published in this link:

    http://www.tradingnrg.com/examining-the-spread-between-brent-oil-and-wti-february-16/

    I address there some of the points you made.

    Lior

  5. Chris T.
    April 13, 2011 at 1:41 am

    The main point here is surely correct, that the indicators addressed are not valuable at predicting where the gap is going.
    BUT:
    There is a historic and valid reason for the difference in the first place, that being with WTI>Brent.

    WTI is the better oil, and US refiners are primarily only able to refine that type, the heavier, the less well we can deal with it.
    The better product, the one more easily (efficiently/cheaply) refined should carry a price premium, as WTI did long term.
    Even for the time after 2006/2007. when you point to the gap-switch, most of the TIME was spent with WTI>Brent, always seeming to return to that historic relation.
    But with wilder swings in both directions?
    (Leaving aside the other component of physical arbitrage, transport costs to the various markets: clearly these do not exhibit the sharp changes over such short time-frames as seen above in the chart, so they are hardly at issue)

    What is REALLY happening is something surely to be decried here, but just as obvious in other commodities:
    MANIPULATION.
    The WTI is most important to manipulate, to keep the monetary-policy produced inflation at bay, at least to some extent. Because this is done (much more) in WTI rather than Brent, the latter is able to go its necessary level, while WTI is manipulatively held back.
    Thus, preventing the easy read by average Joe’s of true inflation, for which one need only go to shadowstats.com
    This is no different with Gold, as all the public-record evidence by GATA demonstrates.
    Ditto Silver, and the extraordinary JPM/HSBC short position.

    As to the value of this overall observation to the point of the article? Who knows, other then that just like this article shows lack of signaling for trading, one should not speculate in markets being manipulated (unless one is doing the manipulating)

    • April 13, 2011 at 2:54 pm

      Hi Chris,

      Thanks for your analysis; it’s a very interesting outlook on this matter. My only comment is that while in the past WTI was usually higher than Brent oil, it wasn’t by a large margin for such a long time as the situation is now reverse.

      Lior

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