Tuesday, July 19, 2011

Closing WTI Crude spread trade (Apr12 x May12) with +0.60pts gain

Earlier today I closed out the short CLJ2CLK2 WTI Crude spread trade opened in 02-March-2011.
Entry price was +0.26 USD/barrel, closing price was -0.34 USD/barrel, for a +0.60 USD/barrel gain or 0.59% gain with the trade size of 100% of the fund, with front-month WTI trading at around 102.50 USD/barrel.

The trade:

After the Middle East conflicts broke out earlier this year and global crude prices started to go up fast with an even faster jump in late February I took a step back and dug into the North American situation and thought about global growth implications of such fast move up in energy prices. I remember what happened to the US economy in 2008 (and how fast crude collapsed and the contango became massive) and had in mind the billions of US dollars that north-americans would fill their gas-tanks with x the size of the payroll tax benefit that was passed at the end of 2010 by Obama & Co.

Things didn't seem too promising and I believed that, even if things got a bit worse in terms of geopolitical stress (as they did, supporting prices up to this day) the supply situation around the WTI delivery point wouldn't change much therefore not heralding such premium on the curve compared to the previous averages for 2009-2010, same 'tenor'.

Market Prices and dynamics:

In early January, before the conflicts made the news, the WTI Crude was trading with a 5 to 1.5 USD/barrel discount to Brent. The discount was 5 at the front month and then decreasing until this discount stabilized around 1-1.5 USD/barrels further down the curve.

WTI's contango was quite large around 5-6 USD/barrel from 1st future to top of the curve around 10-15 months down the curve.

At the same time Brent future's curve reflected much tighter fundamentals across the Atlantic.
Brent front-month future versus top of the curve futures around 1.5-2.5 USD/barrel and prices, as mentioned above, already higher than the WTI.

Even in-land American crude prices had a premium versus the Cushing, OK WTI benchmark. Why?
Inventories kept piling up at the delivery point and this reached an all-time high in 1Q2011.

By law the US cannot export crude so another positive for the trade
Doing some back of the envelope calculations, inherited from my times trading physical soybeans in the brazilian Midwest I checked shipping costs around the US and read a bit about crude transportation issues in the U.S. Paying this transportation costs (and related) wasn't worth it to match the premium in other places.

That gave me some confidence that weak demand, ample supply and technical barriers wouldn't make it too easy for crude to flow away from Cushing and things wouldn't change too fast in terms of inventory levels.

The "too fast" was the 'information' that I needed because I thought that this was the end-game for the trade. With a size of 1x the fund a fast change wouldn't allow me to stop-out where I wanted. I needed this comfort (that yes, sometimes means nothing).
This trade was basically a carry trade, betting on an ending to stressed-conditions in a crude market that seemed rather well supplied warranting no premium.


As the MENA issues became more clear and they made headline news crude prices of all kinds started moving upward and the curves started to shift. Brent further and faster, WTI following reflecting the distance the Atlantic is from the Middle East / Europe / North Africa and the still lagging fundamentals of the U.S. economy and great output capacity from Canada.

Egypt's mess erupted, followed by Lybia, a great supplier of crude oil to Italy. And chaos was instated in the energy markets.
In a few days market moved up by ~20% and the stable price of the spread exploded upwards.

There had been some refinery shut downs in the US. Canadian crude was flowing down from the North and stocks were plentiful, while imports were around 8-9 year lows. That meant lower demand for me. And since I am strong believer that the US is not doing well if you consider the amount of monetary and fiscal stimulus... there you go. Some type of bear trade or carry trade could be profitable.
When analyzing Total Crude and Products supplied, historically, these numbers had also been low.

So... trade on back then.

Getting out now as I believe there is little upside left unless you believe global activity will  decrease further. The previous 3-5 USD/barrel contango in the front-end of the curve was what I aimed, but with prices 20% above 2010-year-end-levels I do not think these will will materialize and holding the trade to gain 4-10 cents do not seem a great return. I'd rather add risk somewhere else.
Let's treat apples as apples and leaves oranges for another day. The trade was about normalization in WTI spreads and carry.

It happened.

Now moving on...

Some interesting charts below:


*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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