Thursday, January 12, 2012

What's driving Brent-WTI spread wider

The spread between the two benchmark oil indices Brent and WTI has widened substantially recently.

Brent-WTI futures spread (Bloomberg)

The most common explanation for this widening has to do with changes in the relative weights of Brent and WTI in the S&P GSCI commodity index and the Dow Jones UBS commodity index. The chart below shows how weights were adjusted in the GSCI index.

Brent and WTI weight adjustments in GSCI (Capital Economics)
FT: Investors tracking the S&P GSCI and the DJ-UBS commodity indices started an annual rebalancing of contracts on Monday, which will continue until Friday. Although the process usually has a minor impact on prices, this year investors are moving larger than usual amounts of money between oil futures as both indices have boosted the weight of the Brent contract at the expense of its WTI competitor. 
But that explanation may be a bit too simplistic.  These index adjustments have been known for months and broadcast broadly in the media.
Bloomberg, November 4, 2011: The Standard & Poor’s GSCI Commodity Index will raise the weighting of Brent crude in 2012 as it reduces that of West Texas Intermediate. The index weight of Brent crude traded on the ICE Futures Europe exchange will increase to 17.35 percent from 15.93 percent as the share of WTI traded on the New York Mercantile Exchange decreases to 30.25 percent from 32.59 percent, according to a company statement dated yesterday....

Dow Jones-UBS Commodity Index announced Oct. 11 it will include Brent for the first time in January, with a weighting of 5.31 percent, and cut its WTI allocation to 9.69 percent from 14.71 percent.
These markets are efficient enough for prices to fully adjust based on such explicit news and over a period of several months.  Therefore a more likely explanation for this widening is the uncertainty around Iran.
Capital Economics: ... the bulk of the recent widening in the Brent-WTI spread in particular can be explained by the heightened concerns over Iran.
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