Oil, always one of the hottest topics in the news due to its volatility and its affect on our everyday life, has spurned a trend on Wall Street to cook up new Energy related investment products for retail investors. Four years ago the first ever ETF based on the spot price of Oil was born The United States Oil Fund (USO), it has now become one of the most popular and heavily ETFs traded in the market.

Moreover a litte over a year ago the same company who put out USO, introduced The United States Brent Oil ETF (BNO). This ETF instead of tracking the price of West Texas Intermediate Crude Oil, tracks the spot price of Brent Crude Oil.  Brent Crude Oil is made up of different types of oil found in the North Sea and it is heavier and not as sweet at West Texas Intermediate Crude or our US based oil.

Historically over the last 20 years WTI Crude Oil has traded at or near the price of Brent Crude Oil but over the last nine months this spread has changed dramatically. Today Brent Crude is currently selling at more than a $24 premium to WTI. This has occurred for multiple reasons, the biggest being the political unrest in Libya and Nigeria has caused the supplies of Brent to be very tight and volatile. While the supply of US Oil/WTI is not as tight as Brent Crude Oil and there is not a political risk premium built into, the the Supply of WTI is still low and does not justify a $24 discount to Brent Crude.

The price of both types of Oil are still driven by demand, (especially consumption from China which has begun to slow) and the overall direction of the Global Economy, which is why I see this spread narrowing very soon. The EuroZone has also experienced numerous economic shocks, from a potential default in Greece, to a huge decline in the Euro (which has already happened the US Dollar is up over 10% vs the Euro in the last three weeks)and there is very likely the probability of a major recession throughout all of Europe.

Therefore with a strengthening US Dollar, a US Economy that is relatively stronger than Europe, and a lack of political risk in Libya and Nigeria, there is no fundamental reason why Brent Crude Oil should sell at such a historical premium to WTI crude (Or US oil). Basically this is a bet that the combination of the US Dollar versus the Euro and the relative strength of the US economy versus the European Economy, will drive this premium back down to its historical norms.

Before last year unless you had a futures account it would be impossible to trade this spread, but again through the recent introduction of new ETFs, retail investors now have the ability to make this simple long short spread trade.

To profit from the huge premium that Brent Crude Oil sells to WTI Oil, you would buy the United States OIL ETF (USO) and sell short the United States Brent Crude OIl ETF (BNO) and do this in equal dollar amounts. For example, if youI had $10,000 to invest in this trade I would buy $5000 of the US OIL Fund (USO), which is 161 shares at USO’s current price of $31 and sell short 71 shares of BNO at its current price of $70.22. This is what is called a market neutral trade, in that you have an equal amount invested long in one ETF short in another ETF, this is important because it also means if the trade works out that the Brent Premium collapses vs WTI, it will happen regardless of whether the price of oil goes up or down.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>

 
Zacks Investment Research