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Friday, May 13, 2022

Brent-WTI Spread Trade

By Century Financial in 'Investment Insights'

Brent-WTI Spread Trade
Brent-WTI Spread Trade

* 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.

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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.

Risks & Assumptions

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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 difficulty 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.
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Holding cost is subject to change impacting the trade either negatively or positively;
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If the spread comes down to -$0.16, 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 -$0.16. 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 $1.5 (Brent Premium on WTI). The lowest in the last five years has been -0.16, while the highest in the previous five years has been $10.99 on a weekly closing basis. As can be seen in the chart, the $1.0-2.0 spread zone offers crucial support, and the spread has bounced from this zone multiple times in the last few 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

Strategy payoff chart

Source: Bloomberg
Date: 13 May 2022

Fundamental Analysis

Brent-WTI spread had surged to as high as $6.75 in March 2022 before retreating back to $1.5 levels. China’s covid curbs can be attributed as one of the major reasons behind the underperformance of Brent versus WTI. The expected slowdown in China’s GDP due to covid curbs and its impact on oil prices- especially Brent crude oil seems to be discounted by the markets. Going forward, as and when China eases its lockdowns and covid curbs, it should be favourable for Brent crude oil.

Besides, the prospect of a European Union ban on Russian oil remains high, after Moscow imposed sanctions this week on European units of state-owned Gazprom and after Ukraine stopped a gas transit route. According to the International Energy Agency report on Thursday, Russian oil output is expected to fall by nearly 3 million barrels per day (bpd) from July, or about three times more than is currently displaced, if sanctions for its war on Ukraine are expanded or if they deter further buying. These factors favour a widening spread.

The Brent crude oil Oct 2022 contract is currently priced at $103.2, while the WTI crude oil Sep 2022 contract is priced at $101, implying a spread of $2.20. 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 5000 units of Crude oil Brent Oct 2022 and simultaneously 5000 units of Crude oil WTI Sep 2022 are short, it would result in a potential profit of ~4.3% (2x leverage) if the spread were to increase to $6.5. On the other hand, if the spread were to reduce to -$0.16, it would result in a potential loss of 2.4%.

Scenario when spread increases/decreases
Expiry No of Units Current Price when spread is 2.2 Invested Amount Price* when spread increases to 4.5 Potential Profit when spread increases to 4.5 Price* when spread increases to 6.5 Potential Profit when spread increases to 6.5 Price* when spread reduces to -0.16 Estimated Loss when spread reduces to -0.16
Long Brent Oct 2022 30-Aug 5000 103.2 $516,000 106.25 $15,250 95.5 ($38,500) 100.50 ($13,500)
Short WTI Sep 2022 22-Aug 5000 101 $505,000 101.75 ($3,750) 89.00 $60,000 100.66 $1,700
Spread 2.2 $1,021,000 4.50 $11,500 6.5 $21,500 -0.16 ($11,800)
Expected Return 2.3% 4.3% -2.4%
Expected Annualized Return 8.3% 15.5% -0.16 -8.5%
Risks and Assumptions for Back-tested trading strategies
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The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
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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.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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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.
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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.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Data & Prices as of: 13/05/2022

Arun Leslie John
Chief Market Analyst

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