How to see arbitrage happen in slow motion

Photo by NIOSH

The free market concept makes predictions. One prediction, is that excess profits are a signal for competitors to enter the market.

If gold is traded on two markets, and the price in one market is different than the other market, that is a signal that buying gold in one market and selling it in the other can make a profit. That profit however is not yours alone. Others will want to make this trade as well. And these new trades increases the demand for the cheap gold and increases the supply of the expensive gold. The logic of supply and demand pushes the prices toward each other. The prices are pushed just to the point that no new investors are interested in trying to make the trade, and current investors are tempted to give up on the trade. The profits become vanishingly small.

This is what is meant by the efficiency of the free market. The trade that buys in a cheap market and sells in an expensive one is called arbitrage. Arbitrage is a key factor in the operation of free markets.

But this is a theoretical discussion. It sounds great in theory, but can you see it happen in the real world? If you watch the stock market, prices change so quickly, and have so much hidden information, that understanding what is going on is difficult at best. Clearly seeing that the market is living up to free market predictions is harder still. There are examples, like exchange traded funds (ETFs). But ETFs only show you that the price in two markets are the same, not how they get there. I’ll explain ETFs at another time.

What I want to show you is two markets that sell the same “commodity”, but have different prices. The simple prediction is that shouldn’t happen. It is happening, and there is a reason for it.

I am talking about the price of oil. Oil is a natural resource that is mined from the earth. But oil deposits are distributed around the world. To sell oil in a different market, requires transporting the oil to a new location. Transporting costs money, if there is even a method of transport available.

Well currently the price of West Texas Intermediate Crude Oil (WTI Crude Oil) is $108.15 while the price of Brent Crude Oil is $122.36. That is an arbitrage opportunity of $14.21. There are reasons, involving transportation problems, that account for the price difference. And there are motivated business people that plan to profit on the price difference. But those plans involve fixing the transportation problem, and that takes time.

So by watching the price of WTI Crude and Brent Crude over time, I predict you will see the prices get closer and closer together. Erasing the arbitrage opportunity in the process. There is a pipeline going in the wrong direction, that if operating in the low to high price direction would cost only one dollar a barrel. So, unless someone can find a better transport method than a pipeline, a $1 difference is probably the limit to the arbitrage.

WTI Crude and Brent Crude for a long time, and as recently as last year were always very close together in price. We will see that time again.

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