An Obvious Oil Trade That Still Has Potential

Many traders tend to overcomplicate things. They believe that because financial markets and the relationships between them are inherently complex, only complex systems and analysis should be trusted, and the only idea worth considering is the obscure one. In reality though, successful trades are often found by ignoring all of the complexities and simply doing the obvious. Right now, for example, there are two contradictory forces in the global oil market that suggest an obvious trade, yet I'm sure many people are looking beyond that.

Those two forces are both on the supply side of the equation.

Globally, supply is tightening. The U.S. sanctions on Iran were reinforced this week when the White House essentially revoked the waivers that were granted when the policy was originally put in place. That will lead to reduced exports from Iran at a time when the OPEC plus group, aggressively led by Saudi Arabia, are still cutting their production.

In the U.S., on the other hand, as this week's inventory numbers once again indicated, output is increasing. Crude inventories increased by 5.5 million barrels, even as refinery inputs jumped by over half a million barrels a day. It is always dangerous to read too much into one weekly data point, but this is a continuation of a trend and is only logical. As the OPEC group's actions have forced the global price of crude higher, so it makes increasing sense for producers in the U.S. to step up output to take advantage of higher prices.

The obvious conclusion is that while upward pressure will remain on global benchmarks such as Brent, the main American benchmark, WTI, will be relatively soft. The demand situation also supports that contention. European data is still suggesting slowing there and the jury is still out on China, but corporate earnings and other numbers in the U.S. indicate that the expected Q1 slowdown was nothing like feared.

In that context, betting on a widening spread between the two benchmarks looks like a no-brainer. The only problem is that this is nothing new.

(Click to enlarge)

The above chart shows WTI relative to Brent, meaning that as the spread increases, the line slopes downwards. As you can see, the spread has been increasing since the beginning of this month, so some may feel that they have missed the opportunity. There is, however, an old market saying that while "buy low, sell high" is a good idea, a more practical approach is to "buy high, sell higher". That recognizes the power of momentum, and as long as the fundamental conditions that caused a move remain in place, that move can continue. With the Brent/WTI spread, not only are the fundamental conditions still in place, this week's events have actually amplified them.

Sometimes, looking beyond the opportunity staring you in the face is a mistake. Selling WTI and buying Brent to benefit from the spread widening may be an obvious trade, but that doesn't make it a bad one.