London, 1 February 2011

Over lunch many years ago, a senior commodity trader told me the secret to executing a successful squeeze is to work with the grain of the fundamentals, not against them.

Successful squeezers identify a commodity market that would already be tight based on supply-demand-inventory fundamentals, then establish a commanding position enabling them to push prices further, making the tightness much worse than it would have been in the absence of the squeeze.

Fundamental imbalances give the squeezer a temporary window to exercise pricing power before supply and demand have a chance to react. Interweaving with the fundamentals is the one reason economists and statisticians find it hard to separate the impact of squeezes and speculation on market prices.

But most squeezes leave tell-tale traces -- usually a sharp and accelerating increase in an outright price or a spread, coinciding with a dominant position in either derivatives or the underlying commodity, and an equally sharp collapse and reversion close to the mean once the contract has expired or the dominant position holder exits the trade.

ARBITRAGE CLOSED

The recent surge in the Brent-WTI spread bears some hallmarks of a squeeze, or at least a mini bubble. WTI has moved from a discount of $3.07 to Brent on Dec 31 to as much as $12.50 per barrel on Jan 28, before pulling back again sharply to trade as low as $8.96 on Monday.

There are sound fundamental reasons for U.S. crude to trade at a discount given the localised glut of oil around the NYMEX delivery point at Cushing and across the rest of the U.S. Midwest ( PADD II). Midwest crudes need to trade lower to shut off the flow up from the Gulf Coast (PADD III) and encourage local refiners to maximise their output and relieve pressure on regional storage.

But nothing can account for the quadrupling of the spread in the space of four weeks. Stocks at Cushing and across the rest of PADD II have been stable since the start of the year. While some discount for spot crude is necessary, it is not obvious front-month discounts of $2 per barrel and more than $12 to Brent are needed to relieve congestion.

Once the arbitrage between WTI and Brent, and PADD II and PADD III, was closed, however, there was no limit to how far the spread could widen. With the arb closed, WTI and Brent have begun to trade as separate commodities; there was no practical limit to how far their prices could move apart in the short term.

No market participant could take a short position in the spread (buying WTI, selling Brent) and rely on being able to take delivery of WTI and redeliver against the Brent contract.

The spread became (temporarily) delinked from fundamentals. Crucially, market participants with long positions in the spread (long Brent, short WTI) have been able to bid Brent higher and offer WTI down to push out the spread with little fear of physical delivery against them. With the arbitrage closed, the only practical limit on the Brent/WTI spread is the need to liquidate short WTI positions at some point to book the profits.

The abnormal Brent/WTI spread appears to have tempted at least some traders to take it on and establish short positions in anticipation that it would revert to the mean or at least closer to historical norms. But as the longs continued to push the spread even wider, many of the weaker shorts have been forced cover, pushing the spread even further, as they are forced to buy back their Brent shorts and sell their WTI longs.

The exceptional volatility in the Brent/WTI spread over the last fortnight is characteristic of a market being squeezed or suffering a dramatic fall in liquidity as a speculative bubble nears its climax. If true, the spread will narrow significantly in the next few weeks as the squeezers and speculative longs book their profits.

Ends --

John Kemp, Reuters market analyst – for Commodities Now.

The views expressed are his own.