Brent Crude vs West Texas Intermediate Crude is Mean Reverting

• Posted by Greg Harmon
• on November 16th, 2011

So you missed the initial move of Brent Crude Oil 25% away from West Texas Intermediate Crude Oil, $CL_F, earlier this this because you did not believe it could. That is okay. And now that it is reverting and has already moved back to only a 12% premium you are feeling like you have missed it again. Instead look at it this way, you have two strikes against you. This trade is not over yet but if you do not take action then you are likely to gain the crown as the next strike out king. Take a look. Below is a 6 year weekly chart of the ratio of West Texas Intermediate Crude to Brent Crude. In case you cannot see the long term correlation I have added the solid blue line at 1.00 and the dotted lines 5% to either side. Prior to the recent break the only other major break of correlation reverted quickly and overshot.

Now focusing on the last year of activity, in the close up below, shows the current level at 0.88 has some price history illustrated by the purple tend line, so the Doji that it is working on this week is not unexpected. But notice the major differences as it reaches 0.88 this time. First the Relative Strength Index (RSI) is rising sharply and back into bullish territory. Second the Moving Average Convergence Divergence (MACD) indicator is strongly positive and rising. The Simple Moving Averages (SMA) are still pointing to a lower level, but the 20 week SMA has reversed and is now moving higher. These have all been within the 5% bands in the long run and you would expect the shorter SMA to turn first. Finally the Bollinger bands are expanding as it rises and with the top band sloping the most steeply since price left the long term highway. There is plenty left in this trade. At least 12%. And if history repeats potentially as much as a 25-30% overshoot to the upside. If you are trading crude and are not involved you have not struck out yet, but you are missing out on a great mean reversion opportunity. Don’t go down looking.

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