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Schork Oil Outlook: Shorting the Trend? Remember Keynes

The Bearish Sum of Bullish Parts...

Pointing out the widening Nymex WTI/ICE Brent spread is, at this stage, akin to pointing out a leak on the Titanic, and about as hard to ignore. But what was the iceberg that hit the spread and caused it to blow out from a high print of -$1.67 in December to a low of -$8.24 on January 14th (a 393% increase)?

Well, we always expect a certain degree of variation when contracts approach expiration, and the Brent contract for February delivery did indeed go off the board on the 14th. However, this month’s fluctuation was especially sharp and, if rumors on the grapevine are true, due in part to a single trading firm.

According to a news report released yesterday afternoon, Hetco (partly owned by Hess Corporation) has taken control of “the first eight North Sea Forties crude oil cargoes loading in February” in addition to two Brent cargoes. There are 25 total Forties cargoes, each of which typically comes to 600K barrels.

This may not mean much on the electronic markets, but Hetco has effectively taken control of ~30% of the Forties and Brent physical market in February.

According to Reuters, Hetco is offering these cargoes at higher prices and traders with supply obligations are “going to have to pay up.” That’s quite a squeeze. Keep in mind that Brent and Forties are part of the BFOE (Brent, Forties, Oseberg and Ekofisk) North Sea Bench Mark which is the basis for Brent settlements, and the Brent contract for February rose some 5.20% in its last five trading sessions, almost twice as much as WTI, which saw a 2.85% rise over the same timestep.

Furthermore, as discussed in yesterday’s issue of The Schork Report, Shell shut down four of its platforms in the North Sea due to a collapsed fender and has yet to announce a likely restart date.

Looking ahead, surely these are short term discrepancies, which will be fixed in a few weeks at most, right? And since Brent is a slightly inferior crude (heavier and less sweet) to WTI, it will soon be trading at a discount, i.e., the inter-market spread will return to a positive, correct?

Not quite. As rightly pointed out by the Financial Times' Neil Hume, there is more going on than a single squeeze. Consider the Brent calendar curve against WTI’s calendar curve (illustrated in today’s report). It is not just WTI for March delivery that is cheaper than Brent, but every month out to December 2019 (!). The average discount comes to -$1.956 as opposed to the historical average (2003 onwards) which comes to a $0.821 premium.

From a long term perspective, there are several explanations for Brent’s strength. The UK’s austerity measures and Germany’s stewardship have placed renewed strength in Western European growth — the UK’s jobless claims have beaten analyst expectations for four consecutive months while the German unemployment rate, which had been well below the U.S. unemployment rate since 1991 by an average of 4.62%, has been 1.52% above the U.S. rate since January 2009.

From a fundamental perspective, North Sea production is generally recognized to have peaked in the previous decade. For instance, the UK’s off-shore production, which peaked at 137 million tonnes in 1999, fell to 76.52 million tonnes in 2005 and came to just 61.87 million tonnes in 2009 according to the latest data available.

Thus, the opportunity is there for Brent to remain at a premium to WTI in both the short and long term, which effectively turns the historical market on its head.

As written by Hamza Khan, analyst at The Schork Report, veteran traders who deem this relationship irrational and are thinking of shorting the trend to take advantage of mean reversion, consider the words of Keynes: “Markets can remain irrational a lot longer than you and I can remain solvent.”

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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.