How to trade record oil spreads as Middle East unrest grows

Events in Egypt may have taken a more favorable turn, but the underlying fundamentals are still shaky across much of the Maghreb with tensions rising in several countries.

Both headline and core rates of inflation remain pessimistically high and the tense political climate implies Egypt’s fiscal stance will become even more expansionary.

Despite the departure of Hosni Mubarak from Egypt’s embattled government, the number of weak spots in the country have increased rather than compressed.

Any further political uncertainty – be it in Egypt itself or in nearby nations like Tunisia, where the people’s uprising began, Iran or the Persian Gulf – could dent the country’s ability to attract much needed tourism flows and additional foreign cash.

Is Brent premium the new normal?
Amongst the turmoil, the price of key oil futures hit highs not seen since 2008 as fears mounted over the stability of supplies through Suez, a shipping channel from some two million barrels of oil a day.
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The current circumstances have also caused heightened global interest in Brent as a benchmark, market commentators including Roubini Global Economics (RGE) have pointed out, and Brent and the West Texas Intermediate (WTI) – another of the most widely used oil indices – has started to experience fundamental disturbances amidst the turmoil.

Brent spreads breached intraday records when it surpassed $16 per barrel on Friday ahead of Mubarak’s exit.  And although the current spread is justified, RGE believes it is unsustainable over the mid to longer term.

“The current spread is justified by market fundamentals, supply factors and structural differences, increasing global interest in Brent as a benchmark, the relative term structures and Middle East geographical uncertainty in light of Egypt’s recent upheaval,” RGE’s Shelley Goldberg explained.
‘We believe the discrepancy in the spread, caused by market idiosyncrasies, is unsustainable at current levels and the market will see a reversion to the norm.’

In the meantime, Goldberg expects a higher probability of a future benchmark tug of war along with spates of high volatility in the spread.  The spread between WTI and Brent can be exploited with some tactical bets.

To play the spread between WTI and Brent, RGE believes investors should employ an active strategy – long WTI, which today sits at $84.83 a barrel, and short Brent, priced $102.4 a barrel  – until the spread contracts.

“We suggest an active and tactical approach to trading the spread,” Goldberg said. “For example, scale into a short spread trade (long WTI, short Brent) on the nearby contracts and establish an exit when the Brent discount is restored.”

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