Spread that.

The WTI-Brent spread has gripped the attention of the financial world. Historically trading in a tight band the spread dramatically blew to as high as $28 intraday before plunging just as dramatically to around $9 where it is now – particularly odd considering the greater refining yields and lower sulfur content of WTI.

A bottleneck at the Cushing terminal in Oklahoma, where the Nymex WTI contract is settled, caused incremental Canadian oil to build with only expensive barges to transport the crude to refineries.

Exacerbating the problem was ConocoPhillip’s decision to keep the Seaway pipeline flowing towards Cushing. In doing so the company protected the profits of its Midwest refineries by keeping WTI crude artificially cheap, all at the expense of Canadian oil sand producers who were pushed to breakeven levels.

The sudden tightening of the spread occurred after the sale of Conoco’s 50% stake in the Seaway pipeline to Enbridge for $1.15 billion, which allowed the reversal to take place. Curiously, the spread began tightening as early as October when WTI entered backwardation, a clue that supply/demand story was tighter than thought.

An initial capacity of 150k barrels / day by 2Q12 is expected to expand to 400k barrels / day by early 2013. This will probably displace the use of the congested and expensive barge market from 2Q12-4Q12.

Whenever prices get this out of whack the gods of economics demand a physical respones. In this case rail capacity was immediately planned with the aim of circumventing Cushing, which may induce further tightening as Cushing prices rise to encourage more oil flow through the terminal.

How I’d recommend playing it: inventories at Cushing will likely build up in anticipation of the opening of the Seaway pipeline. The best risk reward is probably in longer dated Brent spreads, while perversely inventories at Cushing may actually build as oil is pumped there in anticipation of the opening of the pipeline. This would push down prices at the front end of the curve, while leaving the back end free to compress below $6.50 – which is the cost of transporting WTI to Brent.

On this theme, selling the March 2012 WTI-Brent spread and buying the March 2013 spread would benefit from a rotation of the curve – simultaneously profiting from any short term widening while betting that by March 2013 the excess inventories have cleared out. Quite a likely scenario.


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