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Geographical limits to arbitrage in the global oil market

- Michael Grote, Matthew Zook, Thomas Heidorn -

For more than 30 years, the world’s main indices for oil prices – West Texas Intermediate Crude or WTI (delivered in Cushing, Oklahoma) and Brent Crude (delivered at four ports in the North Sea) –have moved in sync. This changed dramatically in 2011, when WTI started trading at a considerable discount of up to 30$ to Brent for almost five years. This disparity violated the “law of one price” as arbitrage between markets should quickly reduce these differences.  Crude oil is the most traded good worldwide and its price influences the global economy to a great extent – so this is important.

Crude oil prices Brent and WTI from 1986 to 2016,
Data and Graph Source: Federal Reserve Economic Data (FRED)

Our paper demonstrates the key role played by geography in the operations of seemingly global financial markets. Historically the US’s status as the largest importer of crude oil – and thus the key marginal consumer of oil in the global market – ensured price equilibrium within the US and world markets through arbitrage and created a long-standing norm. When the WTI price increased relative to Brent prices, market actors could purchase oil in the North Sea (or elsewhere adjusting for differences in quality) and ship it to the US as long as the spread was large enough to cover transportation costs and the actor’s profit margin. Arbitrage in reverse direction has not been possible due to three circumstances... Continue reading.