How a World Crisis Affects Oil Prices

Wednesday last week, my friend sent me a text message asking how to profit from tensions in the Middle East through crude oil. At the time, the unrest had been a few days old, and oil prices had already surged more than 6 per cent in a matter of days. I quickly replied suggesting that he should not bother chasing old news since traders have already priced in the worst case scenario. Four days later, I have been proven correct.

I bring up that story because novice and intermediate traders in North America often try to chase news and buy ETFs or options on crude oil, especially when a major conflict could disrupt oil supply. Many times, these traders will realize they are on the losing end of a gamble for a few good reasons.

You see, there are different types of oil used as a benchmark: Brent Crude Oil and West Texas Intermediate (WTI, also known as Texas light sweet) being the two most followed. Brent, which is less followed in North America, but is the largest classification worldwide, is drilled in the North Sea located between Great Britain and Scandinavia. WTI refers to the oil from the U.S. Midwest and the Gulf Coast. Brent Crude contains more sulfur and is often considered lower quality and less sweet in comparison to WTI. As a result, Brent often trades at a discount to WTI.

However, during major world crises, such as the current Egyptian tensions that may disrupt oil supply in the Suez Canal, Brent's value will reflect risks more so than WTI. The temporary risk premium, that is, increase in price, in Brent occurs because the disruption to oil affects a larger amount of people and businesses in Europe and Africa. A crisis in North America would have little impact on Brent which does not typically get delivered here. It would be like walking into a grocery store on the west side of your town or city and there was only one loaf of bread left. People who shop in the west end would bid up the price of the bread. Shoppers in the east side of the town would see little change in their bread prices because they continue to have an ample supply of it.

Today, Brent trades near $100 a barrel while WTI is trading below $90, a rare anomaly that has only occurred once prior to this year. The premium between Brent and WTI are at historical highs, but should revert back at the end of the crisis.

One other reason WTI is not moving up with Brent is because of excessive supply in the USA. Last week, the stockpiles in Cushing, OK were near record levels suggesting demand for oil in the US is very low or production of WTI is very high. Either the case, these would be bearish cases for the asset on a short-term basis.

When trying to make money on speculative trading, it is very important to fully understand how a commodity or asset would move. When purchasing an ETF on a commodity or asset, find out what the asset is tracking as well. Last week, USO-NY and HOU-TSX saw significant volume on the news, but these track the price of West Texas and not Brent. Both stocks are down about 8 per cent since with little volume following. This suggests that buyers last week are still in their positions holding onto losses.

And to answer your question, no, I have not seen a retail investment product that tracks Brent in North America.