The Narrowing Spread Means Higher Crude


"The key to redressing the price imbalance may not be in the market dynamics at all, but in the way some traders have been playing them."

As you read this, I will be in Baltimore, huddled with the Oil & Energy Investor editorial team to discuss some interesting new developments.

That trip may well be followed rather quickly by a flight to Frankfurt, Germany, for meetings on a potentially major push in the European approach to a rapidly changing energy landscape.

I will keep you in the loop on both.

However, today, we need to talk a bit about an important matter unfolding in oil. . .

The Crude Spread is at a Four-Month Low

On Friday, the spread between the Brent price in London and the quote for West Texas Intermediate (WTI) in New York declined to below 20% of the WTI price.

The straight nominal difference of $17.27 is now the lowest it's been since July 6.

And at 18.46%, the spread as a percentage of the closing WTI price (the better way to gauge its actual impact on prices in the U.S.) is narrower than at any time since June 29.

These changes have been rather dramatic—and quick.

On October 20, the same figures were $25.57 and 30%.

Recall that what has transpired for the past 306 consecutive daily trading sessions, continuously since August 13, 2010, is itself unusual. For that entire period, the market has priced Brent higher, despite it being an inferior grade of crude relative to WTI.

I have discussed the reasons, most recently in the last edition ("What the European Debt Accord Means for Oil;"). This time around, we need to consider what the shrinking spread actually reveals.

A part of the explanation lies in where the market is going.

However, another part—perhaps even the primary explanation—reflects how traders have been maintaining the spread as other pressures were building in that same market.

The Drive to "Keep the Spread Alive"

We continue to have surpluses in the U.S. crude oil sector—normally a very restraining influence on price levels.

On the other hand, the Energy Information Administration reported a rise in crude oil inventories last Wednesday, but the market is positioning itself for additional price increases.

Despite Friday's marginal decline, WTI is still up 9.8% since October 20. Brent, on the other hand, has been flat during that same period.

I have noted on several occasions that, when the spread narrows, WTI will be rising to meet Brent, not the other way around.

Put simply, the overall crude oil price trend line is now plotting up, but more so in New York than in London.

However, the key to redressing the price imbalance—that is, the more rapid increase in WTI relative to Brent—may not be in the market dynamics at all, but in the way some traders have been playing them.

The spread itself has been a popular derivative device to offset pressures on both sides of the Atlantic.

So long as Brent continued to rise more quickly relative to WTI (that is, to the extent that the spread trader could bet on the price differential remaining the same or increasing), there existed a hedging tool to offset two separate developments in Europe: the expanding debt crisis and the inability to short financial institutions on the Continent.

Both resulted in a movement of trade from fixed instruments to oil futures (a very fungible commodity in its own right), which served as a separate effective trading asset.

The spread was a surrogate that operated in lieu of conventional shorts. It served a similar function against credit default swaps (but that is another column entirely).

Betting on the spread became, for some traders, the market equivalent to betting on an over/under spread in a football game. It bore little relationship to the reality of the commodity (or who was winning the game), but much to the need to retain the spread (or the point total).

Now some of this resulted from supply concerns in Europe following the Arab Spring in general, and the Libyan uprising in particular (virtually all of the Libyan export volume goes to European refineries).

But what really produced the primary drive to "keep the spread alive" were the moves by futures contract traders.

The likelihood of debt accord in Europe, however, has ended the spread play, basically because a guaranteed depressive influence on bond prices resulting in a premium use of oil futures is also coming to a close.

As a rising market requires short artists to unwind their positions and cover, so also must the debt accord oblige spread practitioners to unwind and cover theirs.

The declining spread means only one thing: New York is rising to meet London.

And that means higher crude oil prices are rolling out around the world.



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