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The Oil Arbitrage: Brent vs WTI

It is no secret that the most important crude oils in the world are the European Brent (extracted by 15 oil fields located in the East Shetland Basin in the North Sea) and the American WTI which is extracted in the US and delivered at the Cushing in Oklahoma. It is well known that the Brent Crude oil has become the global benchmark and it is used to price crude oils worldwide. Although they are extracted in geographically distant locations the chemical composition of WTI and Brent is not exceptionally different because both of them are considered to be “sweet oils” which means that both contain a low concentration of sulphur: 0.37% for the Brent and 0.24% for the WTI. This small introduction is necessary to understand that the supply/demand forces driving price fluctuations are dissimilar and the discrepancy is even clearer if we add that the Brent is exported in the whole Europe and worldwide while the WTI does not leave the US.

The Brent/WTI arbitrage (the word arbitrage is a misnomer because we are buying and selling two different asset classes) is a fairly popular trading technique within the energy sector and its aim is to profit from price discrepancies. The strategy is reasonably simple and it consists of contemporarily selling the WTI and buying the Brent (short arb) or selling the Brent and buying the WTI (long arb). Clearly, this is a spread trading technique rather easy to implement and control because both Brent and WTI futures share the same size (1,000 barrels) while the tick value (1 cent per barrel) equals to $ 10 for both contracts.

How does the trade work? Let’s assume that a trader decides to sell WTI and buy Brent futures (short arb). He sells the WTI at $ 100 and buys the Brent at $ 110 and he will make money if the 2 asset classes will move in opposite directions. If the WTI drops to $ 97 while the Brent closes at $ 112 our hypothetical trader would have made a $ 3,000 profit from the WTI and $ 2,000 from the Brent for each contract traded.

What happens if WTI and Brent move in the same direction? The strategy would still be profitable if the price augment in the Brent market outweighs the rise in WTI futures. If the Brent gains $ 3 and the WTI $ 1.5, the trader would make a $ 3,000 profit from the long Brent position but he would lose $ 1,500 on the short WTI contract which implies that the overall profit would be equal to $ 3,000 – $ 1,500 = $ 1,500

As you can see the trade would still show a profit because in our example WTI and Brent experienced different volatilities and consequently their fluctuations were not symmetrical in terms of magnitude (the first moved 3 dollars and the second only $ 1.5). However, should the Brent had moved lower and the WTI higher the short WTI / long Brent position would have lost money.

The chart #1 shows how the most important oils oscillated since 2009 until 2011:

Brent and WTI futures

It is evident that until 2011both WTI and Brent were moving symmetrically but for some fundamental reasons, such as global demand and some logistic problems with the WTI, the prices started to diverge and the spread became rather large. On the other hand, the narrowing of the arb from September 2011 onwards is mainly due to an increased demand and to the construction of the Seaway pipeline which facilitates the transportation of the WTI from the Cushing in Oklahoma to Freeport in Texas. Let’s have a look at the WTI/Brent spread now:

Brent / WTI spread

The chart #2 shows very clearly that since 2009 until the beginning of 2011 the differential oscillated following a mean reverting process (because it always tended to get back to the 0 line) and it used to fluctuate within fixed boundaries (because it rarely surpassed the $ 2.5 threshold and infrequently remained below the – $2 level for an extended period of time). However, the scenario has quite changed because in 2011 the Brent/WTI spread increased substantially and achieved the $ 25 level. If we go back to the first chart we can immediately understand what caused such a high spread: the Brent price kept increasing while WTI futures prices kept dropping.

How can a trader take advantage of such divergence? When the trade should be triggered?

Buying or selling the oil arb is up to the trader and it depends on fundamental data such as supply/demand forces, industrial productivity, etc but it is possible to identify when the trade could have a higher probability of success. The chart #3 will help us prove our point:

Brent / WTI correlation

The graph shows the correlation (which fluctuates within -1 and 1) between Brent and WTI since 2009 until the end of the 2011 and its interpretation is straightforward: the higher the correlation, the stronger the relationship between the 2 asset classes. The correlation on average is rather high which means that Brent and WTI tend to experience similar fluctuations, although with different volatilities, but there is a second important characteristic that it is very useful in practical terms: the correlation is mean reverting because it tends to drop and then explode again.

In practical terms, all the time the correlation index drops the relationship between Brent and WTI weakens, hence, the probability of dissimilar fluctuations amplify. Conversely, an increasing correlation would imply the opposite scenario.

We now know that a plunge in the correlation index would increase the probability of maximizing our profits because it would highlight that the relationship between the 2 asset classes is not going to be strong and that the spread will likely expand.  However, in real trading conditions we will need specific entry points, some numerical thresholds to look at in order to trigger our trades and the following tables should be a valuable tool for anyone interested in trading the oil arb:

Brent / WTI spread price distribution

Bear in mind that these are not trading recommendations but merely a guide and the price / correlation levels refer to the period 2009 – 2011.

The table #1 represents the price distribution of the Brent/WTI spread. The outcome of our research shows that the lowest price achieved by the spread is $ -5.42 (which means that the Brent was lower than the WTI) while the highest point was $ 26.84. The percentage row displays the percentage of observations below the reported price levels. In other words, the 24.97% of  total observations were below the $ -0.36, almost 50% of the Brent/WTI spread prices were below the $ 2.28 level while the price fluctuated below the $10.98 threshold in the 74.77% of cases. Now let’s see what the correlation key points are:

Brent / WTI correlation distribution

On average the correlation is around 0.82 but in the 25% of cases it dropped to 0.62 and it remained lower than 0.91 almost the 80% of the time. The extreme points are -0.35 and 0.99 that have been touched only once.

 Strategy Analysis

1)   The Brent/WTI spread fluctuated within $ 2 and $ 2.3 most of the time

2)  The correlation is usually fairly strong and it frequently oscillates around 0.78 and 0.82

3)  In order to have a reliable entry point both price and correlation should be out of their ranges. We should be in a situation where there is an evident mismatch

4)  Entry points are signalled by a breakthrough of the aforementioned price and correlation levels because if the arb price is higher than $ 2.3 and the correlation is lower than 0.78 then the probability of success is higher. Needless to say that good opportunities arise also when the arb price is lower than $ 2 dollars and the correlation is higher than $ 0.8

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Send us an email at info@hypervolatility.com with the list of the 3 asset classes you would like to receive the projections for and we will guarantee you a 14 day trial.

Portfolio Hedging: Risky Assets vs Safe Havens

The credit crunch changed the game and we all know it. Financial markets have been completely reshaped, in fact, the old way to invest is not yielding the results it used to and the composition of market participants have been totally revolutionised (perhaps permanently). The attention towards the management of portfolio risk augmented dramatically soon after the 2008 – 2009 and words like “safe havens” and “risky assets” started to consistently appear on many financial newspapers; but how the “safe havens” relate to “risky assets” nowadays? Which markets can today still be considered to be “safe”? The continuous weekly analysis of inter-market relationships that we perform, here at HyperVolatility, brought us to write this research. Let’s proceed with order.

Risky assets are all those markets that are traded mainly for speculative purposes so in this category we primarily find equity indices (S&P500, DAX, Dow Jones, FTSE100, Nikkei225, etc), stocks (Apple, Microsoft, Amazon, etc), some currencies (essentially Euro vs US Dollar and Yen vs US Dollar) and the most popular commodities such as WTI Crude Oil (this list is far from being exhaustive). Clearly, some of the aforementioned markets are more prone to speculation than others because of the nature of their market players (for instance equity indices are mainly traded by hedge funds, banks and retail traders whilst WTI Crude Oil is traded even by large commercial players that enter futures or options positions purely to hedge their physical exposure) so the way they move and react to market news and changes in the fundamentals vary vastly. On the other hand, the “safe assets” are the ones that fund managers and traders use in order to limit losses during sharp retracements in equity indices. In other words, they are employed in portfolio management as a sort of insurance. The markets that have historically played this role are Gold, Japanese Yen, US Dollar, Swiss Franc, Treasuries such as the American Treasury Bond or the German Bund and the “more recent” VIX Index (the adjective “recent” refers to the fact that the VIX Index could not be traded in the past). The reason they are called “safe havens” is because they tend to rise when risky assets fall, consequently, they are inversely correlated to equity indices and stocks; but is it really so? Do they really provide a valuable parachute against crash landings?

In order to answer the above mentioned questions we take 2 risky assets, E-Mini S&P500 and Crude Oil futures, and we compare their fluctuations against American Treasury Bond futures, German Bund futures, Gold futures, Japanese Yen futures and the VIX Index (the weekly analysis of all the aforementioned markets is covered by the HyperVolatility Forecasts service, send us an email at info@hypervolatility.com to know more). The study of the inter-market relationships has been performed using the correlation analysis and the dataset consists of weekly data for the years 2010, 2011 and 2012 (the last observation for the 2012 has been registered on the 24th of August 2012). Let’s examine E-Mini S&P500 futures:

As we can clearly see from the above reported chart the American index is negatively correlated to all the “safe havens”, which means that while E-Mini S&P00 futures were retracing the safe assets were going up and vice versa. Nevertheless, the correlation index fluctuated a lot throughout last years and the fact that Gold and Japanese Yen futures show an incredibly strong positive correlation in 2010 proves what it has been just stated. Therefore, any hypothetical fund manager or trader willing to hedge any S&P500 long position with these instruments would have obtained fairly poor results in 2010. However, it is worth noting that in 2011 and 2012 the futures on the Asian currency performed fairly well and proved to be moderately good when offsetting the risk coming from long positions on risky assets whilst gold futures worked out well only in 2011. Additionally, the futures on the German Bund had a fairly good negative correlation in 2011 but the performances registered in 2010 and 2012 are not really encouraging which means that there were extended periods of time where both instruments (E-Mini S&P500 and German Bund futures) were moving in the same direction. The same thing can be said for Treasury Bond futures, which display a more solid negative correlation in 2012 than German Bund, but the overall performance is still not that good. The only market which showed a constant and reasonably robust negative correlation with E-Mini S&P500 futures is the VIX Index that can be traded via VIX futures and options offered by the CBOE. Let’s now see if the scenario is different for WTI Crude Oil futures:

The chart displays a significant negative correlation and all the “safe havens” seem to be very good when hedging crude oil positions, although, in 2012 there is a considerable positive relationship with Gold futures (we will explain why later). Specifically, Japanese Yen futures and the VIX Index both show a negative relationship which was evidently much stronger in 2011 than it is now and the analysis manifestly highlights that the best products to use, when hedging any crude oil position, are definitely Treasury Bond and German Bund futures because the negative coefficients that they display are very solid and the inverse rapport seems to be quite stable over time.

So, why are Gold futures a sub-optimal choice? There are no definite answers to that but there are two contributing factors which could help to explain what is happening:

1) The CME increased margin calls for gold futures in August 2011, hence, many traders could not afford to keep their positions open anymore and had to cut them. This resulted in a large drop in gold prices, even if investors were heavily using them to hedge against the massive plunge that risky assets experienced over the summer of 2011, and by looking at the above reported chart it is easy to notice that in 2011 Gold futures were the worst performers (the correlation is still negative but it is definitely weaker than the one registered for the remaining “safe havens”)

2) Gold prices are still used for hedging purposes; the only problem is that they are now employed to counterbalance a different type of risk: over-inflation. In particular, gold futures are being purchased to cope with a higher inflation that can be caused by the “expansive monetary policies” recently adopted by the Fed and the ECB (the Fed will purchase 40 billion dollars worth of mortgage backed securities on a monthly basis and the ECB just launched an apparently unlimited bond buying programme). This explains the uptrend in gold prices and the positive correlation with the so-called risky assets in 2012

According to our findings the best markets to use when hedging positions on E-Mini S&P500 futures are the VIX Index, Treasury Bond and Japanese Yen futures whilst Crude Oil futures are best covered by Treasury Bond and German Bund futures with the Asian currency and the VIX being the 3rd best option (they are equally good so we can both place them at the 3rd place in our ranking).

Conversely, Gold prices proved to be the worst performer and the least reliable market, amongst all the “safe havens” analysed in the present research, when trying to minimise the downside risk on equity indices and risky assets.

 

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E-Mini Crude Oil Futures Volatility Forecast (27/09/2011)

E-Mini Crude Oil futures opened at 85.6 on Monday and remained around this level on Tuesday as well but on Wednesday the price action plunged to 84.6 whilst on Thursday a $4 dollar drop dragged futures prices to 80.2 and the week closed at 80.1 on Friday.

The actual volatility is 2.6% (41.2% in annual terms) and the TGARCH curve is evidently showing an upward sloping curve which seems to suggest that further volatility should be expected over the next trading hours. On the other hand, the current readings have been reached only 2-3 times over the past 5 months and all the time the curve surpassed this threshold the mean reverting pressure became so intense that the fluctuations rate “had to collapse” towards its medium term equilibrium point; that is 1.7% – 1.8 % (26.9% – 28.5% annualised).

The Crude Oil market is not following fundamentals anymore. The latest news regarding Crude Oil inventories and Cushing showed a massive draw which, in normal trading conditions, would have pushed the price up but clearly over the last week we “went through” the opposite scenario.

The HyperVolatility team is moderately bullish E-Mini Crude Oil futures because the volatility should probably mean revert and support the price action although some short term retracements are quite likely to occur, particularly in the first half of the week.

Futures prices, ceteris paribus, are likely to retest the $ 83 – 84 area but an ulterior macroeconomics shock would depreciate the Euro, appreciate the dollar and depress oil prices.

E-Mini Crude Oil Futures Volatility Forecast (19/09/2011)

E-Mini Crude Oil futures opened at 88.8 on Monday, retested the 89.95 resistance on Tuesday, dropped to 88.55 on Wednesday, achieved 89.22 on Thursday and closed at 87.85 on Friday.

The actual volatility is 2% (31.7% annualised) and the TGARCH plot is showing a fairly stable volatility curve which is now trading within its medium term average. Nevertheless, the actual level is still extremely high if compared to the average volatility of this market and the fact that the curve is slightly upward sloping could imply that a higher fluctuations rate should be expected in the upcoming hours although the augment should not be critical.

The long term picture is still highly bearish and the fact that the conditional variance is now trading sideways on its equilibrium point could signal that an increased degree of market fluctuations should be expected in the upcoming trading hours.

The HyperVolatility team is bearish E-Mini Crude Oil futures because the volatility curve is probably going to head north in the next hours whilst the price should touch the 83-84 area by Friday.

Needless to say that the FOMC statement can change the overall picture but the high pressure on the Single currency is going to indirectly influence oil prices.

E-Mini Crude Oil Futures Volatility Forecast (06/09/2011)

E-Mini Crude Oil futures opened at 87.5 on Monday, touched 88.8 on Tuesday, settled at 88.9 on Wednesday, dropped to 88.7 on Thursday and closed at 86.7 on Friday.

The actual volatility is 1.8% (28.5% annualised) and the TGARCH plot is showing a curve which is clearly upward sloping and that it seems to signal an ulterior increase in the oscillation rate over the next trading hours. The 1.5% – 1.55% area (23.8% – 24.5% in annual terms) is acting as a support for the conditional variance which inevitably bounce back up all the time the aforementioned threshold get retested.

The fluctuations of E-Mini Crude Oil futures are strongly linked to macroeconomics announcements rather than “micro-exogenous variables” such as demand/supply, inventories, etc and therefore an increase in volatility has to be interpreted as a warning signal.

The HyperVolatility team is bearish E-Mini Crude Oil futures because a spike in the oscillation rate should be accompanied by an ulterior drop in futures prices which are likely to retest the 83 level by Friday.

However, Obama’s speech on Thursday can change the scenario in the case some new fiscal policy measures are going to be announced.

E-Mini Crude Oil Futures Volatility Forecast (30/08/2011)

E-Mini Crude Oil futures opened at 84.4 on Monday, rose to 86 on Tuesday, dropped back to 85.1 on Wednesday, settled at 84.9 on Thursday and closed at 85.4 on Friday.

The current volatility is 2% (31.7% annualised) and the TGARCH plot is displaying an upward sloping curve which, in normal trading conditions should signal more market fluctuations, but not in the case. The volatility explosion which brought the curve to achieve 0.3% (47.6% in annual terms) did not fully mean revert and it is likely that an initial small augment in the conditional variance, in the first half of the week, will be followed by a drop of the oscillation rate.

The oscillation of the price will highly depend upon the macroeconomics data that are going to be released over the next days and the Manufacturing Index as well as Crude Oil inventories are going to have a significant impact on futures prices.

The HyperVolatility team is bullish E-Mini Crude Oil futures because the volatility should soften and favour a recovery of the price action which could retest the 88.5 – 89 area by Friday.

On the other hand, a great deal of attention will be needed during news announcement because a further negative reading of the manufacturing index could cause an explosion of the conditional variance and a drop in futures prices.

E-Mini Crude Oil Futures Volatility Forecast (22/08/2011)

The $87 per barrel was the profit target we gave you once week ago and, once again, the analysis proved accurate. However, the meeting between Sarkozy and Merkel and the US manufacturing index data have badly hit investors’ confidence who rushed to sell all their positions.

E-Mini Crude Oil futures opened at 87.6 on Monday, touched 86.9 on Tuesday, rose 87.4 on Wednesday, plunged to 81.8 on Thursday and closed at 82.6 on Friday.

The current volatility is 2.6% (41.2% in annual terms) and the TGARCH plot is manifestly showing an aggressively upward sloping curve which implies that the high level of market oscillations are likely to remain in the market also in the upcoming trading days. Additionally, it is worth noting that the conditional variance is now trading at a sustained rank and, should the trend continue, the curve could retest the 3.4% threshold (54% annualised) in the next trading hours.

Fundamental figures are not helping either because the recent crude oil inventories figures were quite bearish although altered from the release of US strategic reserves

The HyperVolatility team is moderately bearish E-Mini Crude Oil futures because the volatility is still very high and probably destined to increase even more in the next days. Consequently, future prices could continue to plummet and settle around the $ 77 by Friday.

Oil prices are plummeting primarily because the manufacturing industry is not picking up and many investors are concerned that an ulterior slow down of the economy could decrease the global demand for the black gold.

Nevertheless, some good news coming from Germany and US could “motivate” some investors to buy but it is difficult to remain bullish when the volatility curve does not show any sign of retracement.

E-Mini Crude Oil Futures Volatility Forecast (14/08/2011)

The last week we were bearish Crude Oil and we set $80 as a profit target for our shorts. Needless to say that our forecast was right and the abovementioned goal was achieved at the close of the first day of trading. E-Mini Crude Oil futures opened at 80.9 on Monday, rose to 81.3 on Tuesday, settled at 81.6 on Wednesday, jumped to 85.5 on Thursday and closed at 85.3 on Friday.

The current volatility is 1.7% (26.9% annualised) and the TGARCH plot is evidently displaying a downward sloping curve which seems to have almost completed its mean reverting movement and it is now ready to settle around  the 1.58% – 1.6% level (25.07% – 25.3% in annual terms).

It is worth reminding that the last figures released from the International Energy Agency are quite comforting and suggest that an increase in the industrial demand of oil is already on its way even if the slowdown of the economy made many economists re-evaluate their forecasts regarding the global demand for oil and its derivatives in the 2011.

The HyperVolatility team is moderately bullish this market because the plummet in the conditional variance should now see the market moving sideways in the first half of the week and raise in the second half. E-Mini Crude Oil futures are likely to retest the $ 87.5 – 88 per barrel by Friday but the movement is probably going to be quite slow because the general sentiment is still uncertainty.

Furthermore, the Crude Oil market went through a significant drop over the last 10 days and oil futures are now looking particularly cheap not only to investors and traders but particularly to commercial hedgers and transport companies which will probably try to purchase “on sale oil” in order to fill up their stocks.

E-Mini Crude Oil Futures Volatility Forecast (08/08/2011)

Crude Oil prices plummeted sharply all week long. The violent and constant drop was manifestly caused by the concerns over a slow growth of the economy and bad figures released from the International Energy Agency (IEA). Last week, E-Mini Crude Oil futures opened at 95.2 on Monday, dropped to 93.2 on Tuesday, plummeted to 91.9 on Wednesday, precipitated to 86.4 on Thursday and closed at 87 on Friday.

The current volatility is 2.42% (38.4% annualised) and the TGARCH plot is showing an upward sloping curve which is exceptionally high and that can be used as an efficient proxy for measuring the fear in the market.

The bearish figures released by the IEA and the slow growth concerns are now the predominant feelings amongst investors and traders. Oil stocks are not empty, meaning that no new orders will be entered, and a low growth in US, Europe and emerging markets implies a decrease in the demand.

Furthermore, if we consider that the US dollar is probably going to appreciate against the Euro, we can only come to one conclusion: high volatility and plummeting prices.

The HyperVolatility team is very bearish on E-Mini Crude Oil futures because the volatility curve, already very high, does not seem to provide any signs of weakness and therefore it is reasonable to believe that the oscillation rate will keep rising over the next trading hours. Consequently, futures prices should plunge and retest the $ 80 area by Friday.

E-Mini Crude Oil Futures Volatility Forecast (02/08/2011)

E-Mini Crude Oil futures prices opened at 99.1 on Monday, rose to 99.4 on Tuesday, dropped violently to 97.2 on Wednesday and remained at that same level on Thursday whilst the last closing price was 95.87 on Friday.

The current volatility is 1.78% (28.4% annualised) and the TGARCH plot is displaying a downward sloping curve which is trying to complete its mean reversion process towards the long term balance point which, for this market, is stable around the 1.68% – 1.7% threshold (26.6% – 26.9% in annual terms).

It is important to mention that E-Mini Crude Oil futures are quite close to the $100 resistance level which has been violated only twice in the last 2 years and therefore it is reasonable to expect some choppy trading accompanied by short term volatility rises.

The HyperVolatility team is bearish E-Mini Crude Oil futures because the fairly low volatility curve should mean revert, at least in the short term, and bring some more market fluctuations whilst the closeness of the price action to the $ 100 barrier should keep away many bulls.

Therefore, we expect the market to retrace in the upcoming days and the $ 93.80 threshold could be eventually retested by Friday.

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