During times of uncertainty as are now, it becomes difficult to invest in any market. Several events, economic data and ever-increasing uncertainty along with reduced risk appetite of investors have kept a lid on money inflows and long-term investments in the market.

However, during such times there are different forms of investments which provide investors with a safe tool to invest. One of these tools which reduce the risk of the investors during the time of uncertainty is ‘Spread Trading’.

Safe bet

Spread could be a trade in between any two instruments with a positive correlation between them. Few of the most liquid and famous Spreads in commodities markets are Gold-Silver, Zinc-Lead and Brent Crude-WTI Crude Oil. The Spread trade is safer as it does not consider the market direction of the asset, but considers the volatility between the two instruments.

When both the instruments are positively correlated they move in same direction, but the volatility or the speed of the movement differs. It is this difference which enables an investor to trade and make his investment safer.

In the last few weeks, commodities market has displayed high volatility and similar is the case with the spread between Brent and WTI Crude. Both WTI and Brent crude were normally trading at par till 2011. After 2011, London crude or Brent Crude traded at premium over US Crude, better known as WTI Crude. This difference in both the products is due to various reasons, such as transportation cost, different quality, demand and supply but most importantly, both these products come from different parts of the world.

Varying fundamentals

Though they are traded in international market, due to different areas and quality, their fundamentals vary vastly. The biggest example of this would be WTI crude inventories which come every week. After the inventories announcement, WTI Crude prices moves much more rapidly then Brent Crude. If inventories are lower, WTI crude moves up and reduces the spread between WTI-Brent Crude Oil. Usually Brent Crude is more volatile than WTI crude, due to the size of the market and volume traded in it. So, whenever there is any supply disruption due to maintenance work in North Sea, Brent Crude moves higher increasing the spread between the two.

In the past few days, this spread reached par value and there was no difference between the prices of WTI and Brent Oil. In 2008, the spread touched an all-time low of -$22.89, i.e. WTI traded at a premium over Brent Crude whereas it touched its all-time high recently in 2011 at $27.88. The spread between Brent and WTI began averaging this year at $18 a barrel in January, close to its average 2012 level. Currently the Spread is near $2.5, well below its previous year’s average price.

Uncertainty to impact

We expect the spread between Brent & WTI Crude Oil to move lower initially to reach near -$1 as uncertainty in West Asia can push WTI crude higher. At the same time, lower demand from Russia — the biggest Brent Oil consumer can keep the Brent Oil Crude less volatile. Bottleneck at Cushing, one of the major delivery points for WTI Crude can also help WTI move higher.

When the spread reaches par value or -$1, we expect this spread to move higher till $4-6, the major reason being that increasing demand for Shale products in the US has resulted in ragged demand for crude oil. Also, the current unrest in West Asia is expected to settle soon which again can prove bearish for WTI Crude. Overall, for safer investment, it would be good to Buy Brent Crude and Sell WTI Crude when the spread between them decreases till -$1 to reach near $4 and later to $6.

( The author is Co-Head Retail at Emkay Global Financial Services. The views are personal. )

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