Betting On Oil Spreads: From Money Spinner To Widow Maker

Reuters via Rig Zone ^ | November 25, 2013 | Barani Krishnan & Claire Milhench

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One of the most popular trading bets in oil markets, based on attempts to predict price differences between European and U.S. oil benchmarks, is proving to be one of the trickiest as funds suffer losses after sky-high gains earlier this year.

For a generation, European and U.S. oil price benchmarks rose and fell more or less in tandem, with U.S. WTI crude usually worth a few dollars more than London's Brent.

But in recent years, Middle East unrest and the U.S. shale oil revolution have combined to flip that relationship upside down, decouple it and make it far harder to predict.

American crude became cheaper, European crude more expensive, and - although both benchmarks were comparatively stable on an individual basis - the difference between the two prices became more volatile than ever.

As a result, those placing bets on the spread by buying one benchmark and selling the other have enjoyed the sort of frantic roller coaster that can make some people very rich indeed.

In 2011 - with new U.S. oil production capacity creating a glut and the Arab Spring impacting output on the other side of the Atlantic - some hedge funds and trading houses made hundreds of millions of dollars. They correctly predicted that Brent would become more costly, with Brent's premium to WTI blowing out to $28 a barrel.

This year promised to offer a repeat of that bonanza as the trend reversed. New pipelines carried oil away from the U.S. pricing hub in Cushing, Oklahoma, easing the glut there and rapidly narrowing the spread from as much as $23 in February to almost zero in July. Some commodity hedge funds reported double digit gains.

But for funds betting that this trend would continue, it has gone spectacularly wrong since September.

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excerpt for Reuters content

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Global Crude Oil Prices
http://www.eia.gov/forecasts/steo/report/prices.cfm

Brent crude oil spot prices fell from a monthly average of $112 per barrel in September 2013 to an average of $109 per barrel during October. EIA expects the Brent crude oil price to continue to weaken as non-OPEC supply growth exceeds growth in world consumption. The Brent crude oil price is projected to average $106 per barrel by December 2013 and $103 per barrel in 2014.

The forecast WTI crude oil spot price, which averaged $106 per barrel during September, fell to an average of $101 per barrel in October. EIA expects that WTI crude oil prices will average $97 per barrel during the fourth quarter of 2013 and $95 per barrel during 2014. The discount of WTI crude oil to Brent crude oil, which averaged $18 per barrel in 2012 and then fell to $3 per barrel in July 2013, averaged $9 per barrel during October. EIA expects the WTI discount to average $10 per barrel during the fourth quarter of 2013 and $8 per barrel during 2014.

Energy price forecasts are highly uncertain, and the current values of futures and options contracts suggest that prices could differ significantly from the forecast levels (Market Prices and Uncertainty Report). WTI futures contracts for February 2014 delivery traded during the five-day period ending November 7, 2013, averaged $95 per barrel. Implied volatility averaged 20%, establishing the lower and upper limits of the 95% confidence interval for the market’s expectations of monthly average WTI prices in February 2014 at $80 per barrel and $112 per barrel, respectively. Last year at this time, WTI for February 2013 delivery averaged $87 per barrel and implied volatility averaged 31%. The corresponding lower and upper limits of the 95% confidence interval were $66 per barrel and $115 per barrel.