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5 "Tells" that the Stock Markets Are About to Reverse

The Battle Between WTI and Brent - Why the Oil Price “Spread” is Getting Tighter

Commodities / Crude Oil Apr 30, 2014 - 10:34 AM GMT

By: Money_Morning

Commodities

Dr. Kent Moors writes: The spread between WTI and Brent is tightening again.

What’s “the spread?”…

It’s the difference in price between what crude oil futures cost on the NYMEX in New York (the West Texas Intermediate rate) and the rate set in London (the Brent rate).


As of this morning, this spread stood at 7.2% of the WTI rate (the more accurate way to register its impact in the U.S. market).

It had been as low as 3.6% earlier this month, after hitting double-digit levels for most of 2013, when in some cases the spread jumped to over 20%.

Both of these represent oil that is sweeter (with less sulfur content) than 80% of the oil that is traded internationally on a daily basis.

These futures contracts are the principal “paper barrel” benchmarks against which the prices of the “wet barrels” (actual consignments of oil) are determined.

As this spread continues to narrow, it promises to create some direct consequences for investors.

Let me explain why this situation has suddenly changed…

The Battle Between WTI and Brent

Of course, it wasn’t always this way. Before August 2010, WTI would actually cost more than Brent since it was a better quality of crude.

But there were two things that changed this long-time relationship.

The first was that Brent became far more used as a benchmark in most regions of the world. The second was the growing situation at Cushing, Okla.

Cushing is where the WTI daily price is pegged. It is the single largest confluence of crude oil pipelines in the country. That presented a problem: There was consistent inability to move volume out of Cushing, creating a giant glut.

In turn, that glut depressed the price of WTI even more.

As a result, Brent priced at a premium to WTI for each daily session since August 16, 2010, except one.

Therefore, “the spread” for the past forty months has favored Brent and that has led to some rather direct consequences.

For one, it has actually improved the bottom lines of refineries. The rise in the relative cost of imported volume allowed processors to pass on increasing wholesale prices for oil products. The refiners were actually using more domestic production, as the increasing reserves of unconventional oil (tight and shale) came on stream. But given the integrated nature of the global market, the higher prices for Brent allowed for improved refining margins (and thereby profits) domestically.

For another, the upper hand given to Brent also tended to exacerbate its price volatility resulting from geopolitical events. The Arab Spring, Iran, Syria, Ukraine, unrest in Venezuela, and saber rattling from China all magnified Brent’s price given its closer connection to the broader markets.

And as it stands, Brent remains the standard for European usage, while the continent is far more dependent upon imports from precisely those same areas where unrest has been on the rise.

The Ongoing Effect of Swaps on Brent

Then there is the added element of contract swaps.

One noticeable change taking place in the global oil sector, especially over the past three years, has been the increasing use of swaps to facilitate export exposure without requiring the actual transport of oil.

The following example of an ongoing series of actual swaps provides a very good illustration of how this works. LUKoil (OTC:LUKOY), Russia’s largest independent producer/refiner had two needs.

The first was the need to supply a string of service stations acquired on the U.S. East Coast with oil product. The second was to expand elsewhere in the Western Hemisphere.

The initial demand for gasoline and other oil products resulted in short-term interim agreements with Exxon Mobil Corp. (NYSE:XOM) refineries to provide oil products since most of the retail locations they acquired were either Getty or Mobil branded outlets. But the Russian major also needed additional sourcing as it searched to acquire its own processing facilities in North America.

That was secured from Venezuelan state company PDVSA, who also happens to own the CITGO chain (and several refineries) in the states.

But the relationship developed much further into general ongoing contract swaps.

PDVSA was interested in securing end users in Europe, while LUKoil had the same interest in South America. Neither company, however, could absorb the cost of using tankers to move oil across the Atlantic.

Instead, the two companies swapped consignments.

LUKoil would agree to release oil from its storage terminal in the Netherlands to new PDVSA clients in Europe. Meanwhile, the Venezuelan company would release volume to new LUKoil customers in South America. So long as the grade of oil released in both locations was the same, the buyers could care less.

These swaps have been added to the types used normally by oil traders who are acquiring actual wet barrels in various parts of the world. As a result, the international market has become even more integrated, with prices impacted by exchanges taking place well beyond a particular region or domestic demand base.

This development also supported a higher Brent premium over WTI, since it is the benchmark more relied upon to set crude oil prices worldwide.

The End of the Brent Premium

However, we are now seeing a gradual end to the Brent premium, and with it some changes in the domestic market pricing in the US.

One reason for the contraction in this ongoing spread is the end of the Cushing glut.

New pipeline capacity is now online, transporting crude south to the petrochemical complexes on the Gulf Coast. That is beginning to remove the most apparent artificial depressant on WTI, thereby increasing its price.

Second, as I have previously noted, the emergence of U.S. refineries as the leading exporters of oil product internationally has placed a new stage in contract swaps. This involves crack spreads – the difference between WTI and Brent as applied to the differentials among crude and various oil product rates (primarily gasoline, diesel, and low sulfur heating fuel).

Only a few years ago, the expansion or contraction in the Brent-WTI spread would have been viewed as a primary indicator of raw material pricing only. But no longer.

As this spread tightens, it will affect both refinery profits and their competitive positioning for both servicing the rising domestic demand and expanding exports abroad.

I’ll be following this situation as it develops, since there will be some investment plays to make as a result. So stay tuned.

Source : http://oilandenergyinvestor.com/2014/04/oil-price-spread-getting-tighter/#deeplink

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