For most of history the two main oil benchmarks – West Texas Intermediate Crude Oil and Brent Crude – have traded just dollars apart, with WTI often trading higher than Brent. But in recent months the spread has been widening: Brent Crude is now $20 more than WTI. The discrepancy has been concerning for many commodity investors, and it could get worse. According to a new Citi report, the spread could expand to a whopping $40.
The reason, says Citi, is that Brent Crude, which is based on oil production in the North Sea, is declining, creating a supply and demand imbalance, while production in Western Canada and parts of US, which is tracked by WTI, is booming.
Merrill Lynch also thinks the spread will continue to widen. According to its researchers the spreads have widened because, “America’s foreign fuel dependency is falling relative to Europe. Onshore oil and gas output in North America is growing fast, while Europe is now more dependent on seaborne fuels.”
Unfortunately, this is bad news for commodity investors. Scott Rubin, a journalist for financial website Benzinga, writes the discrepancy will likely “cause tremendous volatility in the commodities markets.”
Spreads widen and collapse so quickly, he says, that people betting against a convergence in the spread could get caught, lose a lot of money and have to raise cash by selling off other commodities.
“The one thing that is for sure right now is that traders putting on bullish or bearish positions in the Brent-WTI spread are playing a dangerous game giving the volatility inherent in the trade,” he writes.
While playing the spread may be risky, buying oil for the long-term is still a sound investment if you believe demand will grow faster than supply. (See my recent CB story on oil for more on that.) James Murdoch, a writer at Hard Assets Investor, an investing website dedicated to commodities, says now’s the time North Americans consider investing in an oil other than WTI.
“Pick the crude that aligns with your investment strategy, whether it’s something U.S. centric or a more global approach,” writes Julian Murdoch.
John Hyland, a portfolio manager and chief investment officer of United States Commodity Funds, says that if you’re bullish on Chinese and Indian growth, then you might want to consider buying Brent.
“If you’re bullish on oil because you’re bullish on India and China, you’re already halfway there to being non-U.S. centric. You’ve already concluded that the price of oil is no longer solely dictated by how many people are going to drive to Disneyland this summer,” Hyland told Murdoch. “So take the next logical step and think about what kind of oil exposure you want to buy.”
Investors can also play the difference using ETFs, but a drop on U.S. inventories could quickly collapse the spread.
Either way, commodity investors should expect plenty of ups and downs, especially as the Mid-East turmoil continues. So if you want to buy oil, pick the one you think will perform best and hold on.