Why prices of Brent and WTI oil differ?

It is like understanding why similar security prices differ across exchanges..

James Hamilton explains the recent widening spread between Brent and WTI crude oil prices.

An influx of Canadian crude through pipelines delivering to the Midwest, along with impressive production gains from North Dakota, are bringing a lot of new oil to Cushing, depressing the price there relative to other locations.

But the fact that more oil is being produced and delivered locally is not an adequate explanation for the price discrepancy. There is a very fundamental economic principle that goods that are close substitutes and easily transported should sell for a similar price even if the fundamentals of local supply and demand differ across regions. The economic force that ensures this is arbitrage. Whenever price differentials emerge, there are very powerful monetary incentives for anyone to buy in the market where the price is low in order to sell in the market where price is high. The consequences of such actions are to drive the low price up and the high price down until profitable arbitrage opportunities no longer remain.

But for some reason, the folks who usually play this game have taken their marbles and gone home. Maybe they were burned by trying to maintain a tighter Brent-WTI spread than true physical arbitrage warrants given the changing supply conditions on the ground, maybe they ran into other financial constraints, or maybe something else in the market scared them off.

But that leaves lots of money on the table right now for physical arbitrage– buy the physical product where it is cheap and sell it where it is more expensive…

He thinks arbitrage would soon lower the spread. But if there are some more risks in Europe, then spread could continue..

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