How to play the oil market's 'bizarre discount'

The end of what the FT's Gregory Meyer calls "a bizarre discount" in the oil market is in sight. And it could be a great opportunity for smart traders.

Back in August I wrote a piece explaining how you could play the gap between two key oil prices Brent crude and West Texas Intermediate (WTI).

Both are priced in US dollars per barrel. As a spread better, you can either bet on the price of one or the other via a single contract (if you think an event will move the global oil price significantly up or down) or you can play them both together using two contracts in what's called a 'pairs trade' (where a piece of news changes the relationship between two different types of oil). In this case, it's the latter rather than the former we're interested in.

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Here are the mechanics. Say, for example, the price of Brent crude is at $115 a barrel and the price of WTI is at $90 a barrel, you could bet on the gap narrowing by selling a Brent crude contract and buying a WTI contract. Or you could bet on the gap widening by doing the reverse.

In each case, you can make money from this 'pairs trade' regardless of which direction the oil market as a whole moves in. The downside is that you incur two sets of bid-to-offer spreads. Also, should the gap between the two contracts widen when you were expecting it to narrow, or vice versa, you could face sizeable losses.

Last month, the gap between the two contracts grew as high as $28. The price of WTI fell well behind Brent due to a glut of supply at Cushing, in Oklahoma the key delivery terminal for WTI. Some firms, including Delta Air Lines, even stopped using WTI as a benchmark for the price of global oil (it lagged the price of jet fuel so badly that it was ineffective as a hedging tool).

But now the reversal of the flow to Cushing through a key pipeline ('Seaway') is expected to relieve that glut.

For spread betters, the narrowing of the gap between WTI and Brent as the WTI price moves up is an opportunity to put on a long WTI/short Brent trade. As JP Morgan notes in the Wall Street Journal, the latest news "has the potential to narrow Brent/WTI at a more aggressive rate". They also note, however, that it is unlikely to change the global price of crude oil in effect making the case for the pairs trade.

Of course, if you think the markets have overstated the impact of this latest pipeline reversal (the gap did narrow sharply on the news) a short WTI/long Brent pair would be the one to use.