By John Kemp
LONDON May 16 U.S. crude futures have
been offered aggressively lower over the last fortnight as the
market scents distress and hunts for the last remaining traders
trapped on the losing side of a Brent/WTI arbitrage that has
gone spectacularly wrong.
For months, prominent oil analysts have been sharply divided
about whether the reversal of the Seaway pipeline from Cushing
in the U.S. midcontinent to Houston on the Gulf Coast would be
enough to cure the glut of crude which has built up in the
central United States, pushing U.S. crude futures to a record
discount against the international marker Brent.
Back in February, Goldman Sachs warned "with the Seaway
flowing crude from Cushing to the U.S. Gulf Coast, we expect WTI
prices to be closely tied to Brent prices, with WTI likely
trading at a $3-5 per barrel discount, reflecting the pipeline
By the end of summer, Goldman predicted the discount for WTI
would narrow to $5, down from more than $11 in late February
("Repositioning our trade recommendation as Brent crosses
$120/bbl" Feb 22).
In contrast, the research team at Barclays told Reuters
reporters recently "Our view is that Seaway's reversal does not
make much of a difference to Midwest balances."
"Domestic production growth and Canadian flows are likely to
dwarf (Seaway's) 150,000 barrel per day takeaway capacity,"
according to Barclays analyst Amrita Sen.
MANY FUNDS MAKE A WHALE
Most hedge funds appeared to have backed Goldman's
convergence thesis, either with an outright long position in
futures and options linked to WTI, or with an arbitrage position
(long WTI, short Brent) designed to pay off if WTI prices rose
faster than Brent (or fell more slowly).
Hedge funds, commodity trading advisers (CTAs) and other
money managers accumulated a near-record net long position
equivalent to 304 million barrels in WTI-linked futures and
options by the end of February, up from 165 million in October,
according to an analysis of reports published by the U.S.
Commodity Futures Trading Commission (CFTC).
While there was also a large speculative position in Brent,
equivalent to 127 million barrels, it was far smaller, in part
as a result of the greater traditional hedge fund involvement in
WTI, but partly reflecting greater confidence in the outlook for
discounted WTI compared with Brent, which was already trading
above $120 per barrel.
However, the convergence trade has backfired spectacularly,
at least for the moment.
Crude stocks around the WTI delivery point at Cushing have
surged to a record 44 million barrels, up from 34 million
towards the end of February, according to the Energy Information
Administration's "Weekly Petroleum Status Report."
Commercial crude inventories in the broader Midwest region
(PADD 2) have swelled to a near-record 107 million barrels, up
from 97 million barrels in February, despite heavy demand from
refiners keen to take advantage of the cheap local crude.
Doubts have begun to set in about how quickly (if at all)
Seaway and other new transport links can stop this glut
building, let alone work down the overhang.
ARB GOES HORRIBLY WRONG
Suddenly, WTI's discount no longer looks like an attractive
shelter from doubts about whether international oil prices are
overvalued and due a correction.
The result has been an unprecedented liquidation of hedge
fund WTI positions. The seven days ending May 8 saw the largest
weekly drawdown in hedge fund net long positions since at least
June 2006, according to the CFTC commitments of traders data
Money managers have cut their net long position from 304
million barrels back to 169 million, the lowest in seven months.
But the aggressive way in which the market has been offering WTI
futures down, compared with Brent, suggests the liquidation is
not fully over, and that there are still some stale longs
seeking to get out.
In recent sessions, WTI prices have consistently been
offered down more than Brent. Since the start of May, Brent
futures for September delivery have slipped by just under $10
per barrel, while WTI is down almost $13. The WTI discount has
widened 23 percent from $12.61 at the end of April to $15.54 in
trading earlier on Wednesday (Charts 1-2).
While the fall in prices partly reflects a cross-market
selloff as a result of fears about default in the Eurozone, and
signs of the recovery running out of steam in Europe, China and
the United States, there is no suggestion that oil demand in the
United States will be hit harder than in other regions.
The marked underperformance of WTI compared with Brent
therefore appears to be due to more oil-specific factors, as the
failed arbitrage unwinds. The remaining WTI longs are being made
to pay a steep price to get out of a painful trade.