By Nia Williams

CALGARY, Alberta, May 14 (Reuters) - Citigroup Inc C.N plans to start trading physical Canadian crude oil, three sources have told Reuters, setting itself up to jockey with banks and traders to fill the vacuum left by other Wall Street giants offloading physical commodity businesses.

Three participants in the Canadian crude market, who declined to be named because they are not authorised to speak to the media, said Citi is in the process of preparing for physical trading of the most liquid Canadian grades.

That would likely include Western Canada Select heavy blend

SHRWCSMc2 , the de facto Canadian benchmark, as well as sweet grades.

A spokesman for Citi declined to comment.

Citi's expansion into the physical market bucks the recent trend of big U.S. banks retreating from commodities trading as tighter government regulations eat into profits.

JPMorgan Chase & Co JPM.N is preparing to sell its physical commodities business, including a collection of long-term leases on more than 6 million barrels of storage tanks in Hardisty, Alberta. ID:nL2N0GF1X7

Morgan Stanley MS.N is selling its global physical oil trading business, including its Canadian division, to Russian state-run oil company Rosneft ROSN.MM .

"There has been this negative attention but it seems there's still space to maneuver and to operate profitably, and to serve the needs of their clients," said Raymond James analyst Daniel Marchon. "Citi would not be getting into this if it was not important to their institutional clients."

Citi is seeking to rebuild its commodities trading operations, which focus on power and gas, after scaling back its exposure to energy, metals and agricultural markets following a government bailout during the world economic crisis.

In Canada, Citi would compete with big commodity merchants like Vitol, Glencore and Trafigura, as well as oil producers like Suncor and Cenovus.

The bank's revenue from commodities transactions nearly doubled in the first quarter of 2014 year-over-year. Last year Citi was No. 10 among the world's top 10 investment banks in commodities according to UK consulting firm Coalition.

The top 10 banks together made $4.5 billion trading commodities in 2013, Coalition said, down from more than $14 billion in 2008. ID:nL2N0NR1ZV

BARRIERS TO ENTRY

Canadian crude production is expected to more than double to 6.7 million barrels per day by 2030, according to the Canadian Association of Petroleum Producers, making the physical market a potentially lucrative source of trading revenue.

However, the volatility of the market, with WCS discounted at $10 to $40 a barrel below U.S. benchmark crude futures last year, deters some new entrants.

The risk required can be a deterrent, said one of the traders, speaking from Canada's oil capital, Calgary. He said new entrants need access to credit lines and at least 10 to 15 counterparties willing to do business with them.

New entrants also face challenges in attracting business as people need to determine "whether they want to take a risk in doing business with you," he added.

For a bank like Citi, already well-known for trading financial crude contracts and physical barrels in the U.S. oil market, counterparty credit is a minor issue.

However, a sticking point could emerge over what general terms and conditions govern trading. One source said industry standard is either BP Plc's BP.L or ConocoPhillips' COP.N terms and conditions because they have been around a long time and are seen as the most fair to both buyers and sellers.

If Citi insists on counterparties signing up to the bank's own proprietary terms and conditions, setting up trading partners may be a struggle.

None of the sources were able to say whether Citi had entered into talks to buy or lease storage space, which enables market players to ride out the more volatile price swings often caused by heavy congestion on export pipelines out of Canada. The exact timing of the launch is not yet known.

(Editing by Eric Walsh)

((nia.williams@thomsonreuters.com)(+1 403 531 1624)(Reuters Messaging: nia.williams.thomsonreuters.com@reuters.net))

Keywords: CITI TRADING/CANADA CRUDE