The WTI-Brent spread is the difference between the prices of two types of crude oil, West Texas Intermediate (WTI) on the long side and Brent Crude (Brent) on the short side. The two oils differ only in the ability of WTI to produce slightly more gasoline in the cracking ratio, which causes WTI’s slight pricing margin over Brent.

As both oils are very similar, their spread shows signs of strong predictability and usually oscillates around some average value. It is, therefore, possible to use deviations from the fair spread value to bet on convergence back to fair value. The fair spread value could be calculated via moving average, regression, neural network regression, or other procedures. We present moving average calculation as an example trading strategy from the source paper.

Fundamental reason

Both oils differ in chemical compositions, and they also differ in production and transportation attributes. These differences are reflected in the price spread between both futures contracts. The spread is mean reverting because most of the price shocks are only temporal, so the spread moves back to its long term economic equilibrium, and therefore it is possible to create a trading strategy based on this mean reversion. Caution should be only needed in utilizing parameters from the source paper as they are based on the short history and, therefore, could be susceptible to data-mining bias.

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Markets Traded
commodities

Backtest period from source paper
1995-2004

Confidence in anomaly's validity
Moderately Strong

Indicative Performance
9.92%

Notes to Confidence in Anomaly's Validity

OOS back-test shows slightly negative performance. It looks, that strategy’s alpha is deteriorating in the out-of-sample period.


Notes to Indicative Performance

per annum, calculated as weighted average of in sample and out of sample period, data from table 5


Period of Rebalancing
Daily

Estimated Volatility
11.27%

Notes to Period of Rebalancing

Notes to Estimated Volatility

worse number from in and out of sample period, data from table 5


Number of Traded Instruments
2

Maximum Drawdown
-5.58%

Notes to Number of Traded Instruments

Notes to Maximum drawdown

worse number from in and out of sample period, data from table 2


Complexity Evaluation
Simple strategy

Sharpe Ratio
0.88

Notes to Complexity Evaluation

Region
Global

Financial instruments
futures

Simple trading strategy

A 20-day moving average of WTI/Brent spread is calculated each day. If the current spread value is above SMA 20, then we enter a short position in the spread on close (betting that the spread will decrease to the fair value represented by SMA 20). The trade is closed at the close of the trading day when the spread crosses below fair value. If the current spread value is below SMA 20, then we enter a long position betting that the spread will increase, and the trade is closed at the close of the trading day when the spread crosses above fair value.

Hedge for stocks during bear markets

Not known - The source and related research papers don’t offer insight into the correlation structure of trading strategy to equity market risk; therefore, we do not know if this strategy can be used as a hedge/diversification during the time of market crisis. Commodities usually have a negative correlation to equities; therefore, the proposed strategy can be negatively correlated, too, but a rigorous backtest is needed to asses if this is the case …

Source paper
Out-of-sample strategy's implementation/validation in QuantConnect's framework (chart+statistics+code)
Other papers

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