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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved
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Thursday, January 13, 2022

Brent-WTI Spread Trade

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 2.8% 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 Brent and WTI crude oil. 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 $2.07 (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

40% THE GOLDMAN SACHS STOCK'S CLIMB OVER 12 MONTHS 40% THE GOLDMAN SACHS STOCK'S CLIMB OVER 12 MONTHS

Fundamental Analysis

Reports suggest the economic impact of Omicron could be short-lived, with Fed chair Jerome Powell recently assuring the markets that the ensuing quarters could be very positive for the U.S. economy after the surge driven by the variant subsides. OPEC and its Russia-led allies had the same story to narrate and appear increasingly confident that the omicron variant will take a limited toll on global oil demand. As a result, OPEC+ recently narrowed its forecast of the market's oversupply to 1.4 million barrel-per-day (bpd) for the first quarter -- less than half of the 3.0 million bpd surplus they estimated a month ago.

While the U.S. government has raised its oil demand forecast, it has subsequently lowered its oil output growth estimates. Accordingly, total oil demand in the U.S. is seen rising 840,000 bpd for the year, higher than the 700,000-bpd increase expected last month. Moreover, it is estimated to grow by another 330,000 bpd in 2023. Meanwhile, production is estimated to rise by 640,000 bpd this year, lower than the previous month's forecast of a 670,000 bpd increase. This will essentially force the U.S. to rely on international supply and build up pressure on Brent prices.

Meanwhile, although OPEC+ has been slowly easing record output cuts made in 2020, lack of capacity in some OPEC nations has kept supply additions below the 400,000 bpd increase agreed to last year among the group. Meanwhile, recent outages in Libya have also supported Brent prices, with the National Oil Corp saying it was suspending exports from the Es Sider terminal.

A combination of factors - where demand is expected to be stronger than anticipated while OPEC's supply may not grow as fast as the market needs - is why Brent crude oil may continue to outperform WTI crude oil.

The Brent crude oil June 2022 contract is currently priced at $82.47, while the WTI crude oil May 2022 contract is priced at $80.27, 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 6000 units of Crude oil Brent June 2022 and simultaneously 6000 units of Crude oil WTI May 2022 are short, it would result in a potential profit of ~5% (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 2.8%.

Scenario when spread increases/decreases

No of Units Current Price when spread is 2.20 Invested Amount Price* when spread increases to 4.0 Potential Profit when spread increases to 4.0 Price* when spread increases to 6.5 Potential Profit when spread increases to 6.5 Price* when spread reduces to -0.16 Potential Loss when spread reduces to -0.16
Long Brent June 2022 6000 $82.47 $494,820 $88.5 $36,180 $91.15 $52,080 $88.50 $36,180
Short WTI May 2022 6000 $80.27 $481,620 $84.50 ($25,380) $84.65 ($26,280) $88.66 ($50,340)
Spread $2.2 $976,440 $4.00 $10,800 $6.5 $25,800 -0.16 ($14,160)
2.2% 5.2% -2.8%

*Prices in the 6th,8th and 10th column are based on hypothetical scenarios.

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 as of : 13/01/2022

Arun Leslie John
Chief Market Analyst

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