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As of right now, the price of Brent Crude is $\$$111.59/bbl and the price of WTI Crude is $\$$98.36/bbl. I'm well aware that futures markets don't set the spot price for oil, but actual supply/demand does. And, that I don't have access to enough refinery/supplier data to figure out the supply/demand balance for WTI, or the supply/demand balance for Brent. However, common sense says this mismatch in price will eventually close.

Is anyone making any kind of bet on this situation? If so, could you share a general description of how you're controlling risk?

Edit (03/01/2011): For future reference, below is a graph of the spread:

enter image description here

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Your graph is very interesting. The mean reversion seams obvious on you graph, I agree. But if you have time, try to build a theoretical portfolio that is always long WTI and short Brent. I am not sure to see any mean reversion in it. The key here is that nobody can invest in/replicate the spread you have plot. – RockScience Mar 3 '11 at 2:23
@fRed I agree, actual futures/options positions will provide a different picture than what's shown above. However, the one similarity is the "flatness" of the above tops and the "spikyness" of the bottoms. The reason that I'm not playing the game is my fear of the current situation turning into something similar to the above "May 2007" episode (spike after spike). The return to a neutral zone may take many months, and predicting that requires data that I can't get. – bill_080 Mar 3 '11 at 19:08
I have edited my answer with a graph – RockScience Mar 4 '11 at 2:00

3 Answers

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If I were you I would be very cautious when playing this mean reversion. For several reasons.

1/ You never know when this spread is going to close, and the contracts on which you enter the trade may have expired. Then you would have rolled. In fact the arbitrage can close without any opportunity to capture it because of the roll yield. I advise you to play directly on the backend of the curve if you can find contracts that are liquid enough.

2/ The cointegration between daily close prices of WTI and Brent is strong but the mean reverting process may be very slow to move. I would not play this "statistical" arbitrage. High frequency ok, but with daily prices... is it really statistically meaningful?

This is the price of a basket which is long WTI and short brent for the same maturity. Do you see any mean reversion? enter image description here

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I looked at all sorts of schemes, both open ended and with a defined time frame. With all of the unknowns, the risk level was higher than what I normally mess with. So, I gave up. The spread is now 14.41. – bill_080 Feb 28 '11 at 18:10
@ bill_080 eia.doe.gov/oog/info/twip/twip.asp (I could not find the good link then you hqve less than 1 week to click on this) – RockScience Mar 1 '11 at 0:37
If you rebalance the hedge every time the contracts are rolled, you'll get something much closer to the plot in green. – bill_080 Mar 4 '11 at 3:18
@ bill_080: what do you mean? Can you show me a graph? I do rebalance the portfolio at the close everyday so that I have always the same notional in the 2 legs. – RockScience Mar 4 '11 at 8:10
You're graph is probably right. For me to generate that graph is a lot of work, and a "long term hedge" for me is only 2 or 3 weeks. I'm not in a position to hold right up to the close, so my rolls typically happen one to three days before maturity. In any case, any hedge that I configure is an attempt to ride some form of a mean reversion. – bill_080 Mar 4 '11 at 20:41
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There is a surplus of production between the Mexican Gulf and Canadian sources of crude. This makes refineries in the Midwestern US oversupplied driving the price of WIT down.

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A significant portion of the price difference between different types of oil futures has to do with whether their sulfur content(heavy, light, sweet).

If supply and demand for each are in equilibrium they should not have the same price.

However, both brent and wti are light, but brent is not as light as wti (brent has more sulfur). More sulfur, means more loss in refining, which means that the equilibrium price of the heavier, brent, is higher than wti.

The fact that the prices are contango-ed suggests a demand imbalance in brent... perhaps produced by the fact that there are supply concerns(opec basket) stemming from the political crisis in libya. Libyan oil(opec basket) is not technically brent, but lack of supply there can contribute to a demand surge in brent.

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WTI costs less to refine and "normally" costs a little more than Brent. A few months ago, as WTI stocks rose in Oklahoma, WTI's price dropped below Brent. With the current entertainment in the Middle East, there appears to be enough WTI. However, with the possibility of a loss of suppliers (that price with Brent), the price of Brent is moving up. Common sense says this will reverse, but when? And how? Is there a reasonable way to take a shot without getting your clock cleaned? – bill_080 Feb 23 '11 at 23:17
@bill_080: You could buy a call spread on WTI and a put spread on BRENT, both in the same month. It's not arbitrage, but the risk is well defined... – glyphard Feb 24 '11 at 7:04
The slop in option prices would force me to pick a time frame. I'm a bad time picker. The above spread was 13.23. It is now 15.01. Any "mean reversion" bet set yesterday is under a lot of water today. – bill_080 Feb 24 '11 at 18:57
@bill_080: nothing says that you have to place the spreads at the money. Depending on the vol difference between the two, it's still possible to make money even if the spread doesn't come in before expiration. – glyphard Feb 25 '11 at 15:59
I disagree. The main difference between WTI and Brent is the delivery location. For WTI it is Cushing, which is inland, far from the coast. For Brent it is anywhere in the North Sea (The contract is settled against a 15 days forward contract for delivery anywhere in the area, to be defined between the buyer and the seller). The difference in quality is actually small compared to the issues that meet both WTI (glut in cushing and no pipeline to send back the oil to the coast) and Brent (scarcity of Brent oil due to field depletion). – RockScience Feb 28 '11 at 10:28

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