Short Brent/Long WTI: an "obvious" trade?

Emptyend recently mentioned an FT article which I had previously read, commenting on the disparity in the oil price for WTI crude and Brent.

The price difference between the world’s top oil benchmarks reached an intraday record of more than $16 a barrel, doubling in three weeks, as West Texas Intermediate oil disconnects from top global oil references Brent and Dubai. The spread fell back to just above $14...

Historically, Brent trades at a discount to WTI as the Brent blend is slightly lower "quality" than WTI (West Texas Intermediate).

It occurred to me that, surely, this pricing anomaly cannot persist forever? Eventually, physical traders must surely take advantage and buy cheap oil from Cushing and sell it at a substantial profit on the world market? This Bloomberg article comments on the anomaly further:

Oil Supplies Rise in Survey on Cushing Pipeline: Energy Markets

U.S. crude stockpiles rose for a fifth week as TransCanada Corp. completed an extension of a pipeline to Cushing, Oklahoma, adding to a glut at the country’s biggest oil-trading hub, a Bloomberg News survey showed.

U.S. Oil Glut May Be Eased by Seaway Pipeline Reversal, JBC Says

A reversal of the Seaway Crude Pipeline System may reduce the record discount U.S. benchmark West Texas Intermediate incurred versus North Sea Brent, according to Vienna-based researcher JBC Energy GmbH.

The latter headline illustrating the point that eventually, physical oil will be moved in the most profitable direction. This seems to me to open up an obvious and relatively low risk trade: to go long WTI and short Brent. I have duly done so (in very modest size to begin with) on the April contract. Should the anomaly not have corrected before expiry in late March, I intend to roll these contracts.

Here is a table of recent closing prices for these contracts.

I have managed to open my trade today with a spread of $14.18. Let's see how it goes. :0)

Further Research and Data

The above represents my initial view, data and knowledge on opening this trade, for reference. And it may turn out to be naive... Below, I will maintain my table of spread data for the April WTI contract and the Brent May one , going forward. [see later for why I have switched the Brent contract to the May one].

Many thanks to the readers that have pointed out possible flaws in my thesis, helping to steer me in the right direction for further research.

Physical Arbitrage

As mentioned above, the thesis behind this trade is that the spread cannot widen forever and that eventually, physical oil traders will take over and arbitrage the spread away. What does that mean, in practice? Considering the April WTI contract that I am buying, it means that they will also buy those contracts, take delivery of the oil at the contract price and arrange for shipment to Europe or Asia. Simultaneously, they would sell, say, the Brent May (or later) contracts, so that they know what prices they will receive for the oil when it arrives. It is possible that the oil has to be blended before delivery, but I doubt it because Brent is slightly lower quality than WTI, so WTI oil should meet the Brent spec. I find it hard to imagine that shipping costs would be anything like $10/bbl, so buying oil for $87/bbl, shipping it, and selling it a month or two later for a guaranteed $101/bbl would be a highly profitable and negligible risk trade. That process will eventually reduce the spread.

Considering this subtelty (i.e. the delay between buying and selling), it actually makes more sense to short the May Brent contract and remain long the April WTI one. I have rolled my April Brent short at a cost of 18c into the May contract, taking advantage of the current small Brent contango.

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That's the theory, in outline. The question is, can it work in practice? I have heard a commentator say that there is no aribitrage between Brent and WTI, which is what has led to this "spread blowout". So, I thought I'd check that out, and quickly came across this (see post by "gekko21"):

The Brent-WTI (Atlantic Arb) is the most commonly traded oil arb in the world with traders being able to take North Sea Brent and ship it across the Atlantic depending on WTI prices and freight costs----the trade can also go the other way with WTI going to Europe.

Now of course, this is only from a post on a BB, so may or may not be true - but it appears authoritative to me and I tend to believe it unless anyone can provide better evidence to the contrary.

The WTI Contract

Next to check is whether there are any issues concerning settlement of the contracts I'm trading. Here, I can get definitive answers, from the horses mouth:

(A) Delivery shall be made F.O.B. at any pipeline or storage facility in Cushing, Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing storage. Delivery shall be made in accordance with all applicable Federal executive orders and all applicable Federal, State and local laws and regulations. For the purposes of this Rule, the term F.O.B. shall mean a delivery in which the seller:

• provides light "sweet" crude oil to the point of connection between seller's incoming and buyer's outgoing pipeline or storage facility which is free of all liens, encumbrances, unpaid taxes, fees and other charges;
• in the event of the buyer's election to take delivery by interfacility transfer ("pumpover") to either TEPPCO, Cushing or Equilon Pipeline Company LLC, Cushing, from seller's delivery facility, bears the lesser of the pumpover charge applicable for pumpover from seller's delivery facility to TEPPCO or Equilon Pipeline Company LLC;
• retains title to and bears the risk of loss for the product to the point of connection between the buyer's outgoing and the seller's incoming pipeline or storage facility.

(B) At buyer's option, such delivery shall be made by any of the following methods:

• By interfacility transfer ("pumpover") into a designated pipeline or storage facility with access to seller's incoming pipeline or storage facility.
• By in-tank transfer of title to the buyer without physical movement of product; if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer.

(C) All deliveries made in accordance with these rules shall be final and there shall be no appeal.

Clearly only physical oil traders can hold the contract to settlement and actually take delivery of the oil, as specified above. Rulebook Chapter 200 specifies the oil blend/purity that is acceptable for delivery - so oil containing "gunk" would not be acceptable!

Pipelines

So, now to the crux of the matter: how easy is it to get oil in and out of Cushing? Wikipedia proves a nice overview of Cushing:

Cushing is a major hub in oil supply connecting the Gulf Coast suppliers with northern consumers. Cushing is famous as a price settlement point for West Texas Intermediate on the New York Mercantile Exchange^[4] and has been cited^[7] as the most significant trading hub for crude oil in North America. As of 2007, Cushing holds 5 to 10 percent of the total U.S. crude inventory. Signs made of a pipe and valve on the major highways near town proclaim Cushing to be the "Pipeline Crossroads of the World", and the town is surrounded by several tank farms. Most storage tanks are owned by four entities: oil giant BP, and energy-transport and logistics firms Enbridge Energy Partners, Plains All American Pipeline, and SemGroup Energy Partners. On July 13, 2010, BP announced it will sell its assets in Cushing to Magellan Midstream Partners.^[8]

Next, I thought I ought to get a better understanding of the US pipeline network and Cushing's location within it. Click on the thumbnail below to see it properly:

The "key" to the pipeline numbers is here: http://www.theodora.com/pipelines/united_states_pipelines.html

As can be seen from the map, Cushing is around 400miles due north of Houston and the GoM coast, where import/export pipelines converge.

Now, I note the article highlighted by nigelpm, which suggests that Cushing will remain oversupplied and WTI depressed for a very long time. I am sceptical of this, for two reasons. Firstly, the article itself illustrates that with such a large spread, producers will use any means they can to get oil to export terminals where they can achieve better prices. African4life makes the point that pipleines can be "turned around" but that this takes time. This brings me onto my second reason for scepticism: observing the data tabulated above, the WTI/Brent spread has built up awfully quickly. This seems to me more characteristic of a  temporary "bubble" in the spead than a long term shift. If the spread remains so large, surely Canadian producers in Alberta can get their oil out to a terminal on the pacific coast for shipment to Asia, rather than accepting way below market prices in the US? There are plenty of pipelines going to oil terminals on the coast but I suspect that some of them are flowing in the "wrong" direction and it takes time to turn them around - but that's a matter of weeks or a month or two, rather than years. [as the Wiki article mentions, the normal flow of oil is from Texas northwards]

I do not have the detailed information on the pipeline network to be truly confident of this hypothesis (or I'd enter this trade in size!). I will use market behaviour of the spread to guide me.

WTI Contango

Nigelpm made a very good point about the WTI contango being much steeper than the Brent one. ISTM that this is a direct consequence of the current Cushing oversupply anomaly: physical traders will want to buy longer dated contracts because they do not yet have the capacity to export sufficient oil that arrives at Cushing in the near future. This situation should change over time, if my hypothesis is right. If not the contango will eventually kill the potential profitability of this trade.

Mark