Brent and WTI Spread Trade
By Century Financial in Investment Insights*Trading in financial market carries risk and can result in loss of capital.
*This performance is only observed with historical backtests and not traded by the company.
The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.
Risk and Assumptions:
Past performance is not indicative of and does not guarantee future results. Please read the complete disclaimer carefully. Trading pairs is not a risk-free strategy. The diffculty comes when prices of the two commodities move contrary to the positions taken, resulting in losses. Thus, adhering to strict risk management rules is essential when dealing with such adverse situations.
If the spread comes down to -$0.68, the trade will result in a potential loss of 2.4% on $500,000 with 2x leverage. The potential losses could increase further if the spread drops below -$0.68. The strategy is also exposed to roll-over risk if the positions are held beyond the expiry date.
Rationale:
The strategy behind Brent-WTI trade is to take advantage of diversion in price. The spread here is the price difference between the two commodities. Positions are taken when the spread or price difference is too narrow or diverges too far. In substance, the spread is expected to revert to mean over the medium term.
Generic crude oil futures contract
Crude oil spreads based on generic contract is currently at around $4.0 (Brent Premium on WTI). The lowest in the last five years has been -0.68, while the highest in the previous five years has been $11.39 on a weekly closing basis. As can be seen in the chart, the $3.3-$4.5 spread zone offers crucial support, and the spread has bounced from this zone multiple times in the last two years. The highest daily closing was 63 in April 2020, when U.S. crude oil prices turned negative in the wake of the pandemic crisis.
Generic Brent-WTI Spread Chart
Fundamental Analysis
The dip in the spread to -0.68 followed after the Russia-Ukraine Crisis as markets perceived a severe shortage of oil and piled up WTI crude oil. This year the situation seems to be reverse where investors fear recession could hurt oil demand. A slowdown/recession in the US could severely hurt WTI crude oil demand weighing on the prices. Meanwhile, reopening of China is favorable for Brent crude oil. Besides, the recent unexpected output cut by OPEC also works in favor of the spread rallying.
Scenario when spread increases/decreases
The Brent crude oil Sep 2023 contract is currently priced at $85.1, while the WTI crude oil Aug 2023 contract is priced at $81.8, implying a spread of $3.30. Therefore, long Brent and short WTI contracts could result in profitable trade when the spread between the two contracts increases further irrespective of price movement on the upside or downside.
On the other hand, it could result in potential losses if the spread narrows further. For example, in a $500,000 account, if by going long 3000 units of Crude oil Brent Sep 2023 and simultaneously 3000 units of Crude oil WTI Aug 2023 are short, it would result in a potential profit of ~5.7% (2x leverage) if the spread were to increase to $8. On the other hand, if the spread were to reduce to -$0.68, it would result in a potential loss of 2.4%.
*Source: Bloomberg
**Prices in the columns 7, 9 & 11 are hypothetical.
Risks and Assumptions for Back-tested trading strategies
The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
Unforeseen events can lead to variation in performance from the tested trading strategy.
The tested result has been computed with price feeds available from Bloomberg.
The testing environment has not considered transaction or any other costs.
Trading indicators used for the purpose of testing has been provided by Bloomberg.
The strategy might suffer from data mining fallacy, selection bias and backfill bias.
Data Source: Bloomberg
Date: 13th April 2023
Arun Leslie John Chief Market Analyst