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Higher commodity prices are positive for energy companies' earnings

Part 4
Higher commodity prices are positive for energy companies' earnings (Part 4 of 4)

Why the WTI-Brent spread might close in soon

WTI and Brent used to trade in line, but prices had diverged over the past few years

The spread between West Texas Intermediate (“WTI”) and Brent crude represents the difference between two crude benchmarks, with WTI more representative of the price that U.S. oil producers receive and Brent more representative of the prices received internationally. The two crudes are of similar quality and theoretically should price very close to each other. However, the prices had differed greatly between the two crudes because a recent surge in production in the United States has caused a buildup of crude oil inventories at Cushing, Oklahoma, where WTI is priced. This created a supply and demand imbalance at the hub, causing WTI to trade lower than Brent. Before this increase in U.S. oil production, the two crudes had historically traded in line with each other.

2013.12.23 - WTI-Brent LTEnlarge Graph

The above graph shows the WTI-Brent spread over the past few years. Note that when the spread moves wider, it generally means that crude producers based in the United States receive relatively less money for their oil production compared to their counterparts that are producing internationally.

Spread traded slightly wider last week; analysts believe spread will narrow in 2014

The WTI-Brent spread traded slightly wider last week, moving from $12.35 per barrel slightly wider to $12.64 per barrel. Heading into 2014, many analysts believe that the spread will average tighter over the next year. For example, the US Energy Information Administration Administration noted in its latest Short Term Energy Outlook report, dated December 10, that it expects the spread between WTI and Brent crude to average ~$9 per barrel in 2014, compared to the current spread of ~$13 per barrel. Various parties, including the US EIA and analysts at investment banks believe the spread may narrow due to several factors. Firstly, oil production from Libya was disrupted over much of 2013, which helped to support Brent crude prices (see Must-know: Why does unrest in Libya affect global oil prices?) Additionally, there is the potential for more Iranian oil to come online as the country is in negotiations with world powers to relax sanctions, with the potential result of more Iranian oil production and exports. Additionally, next month TransCanada Corp. (TRP) plans to start operating a portion of its Keystone XL pipeline in January, which has to capacity to transport up to 700,000 barrels per day of crude oil from a major hub at Cushing, Oklahoma to the Gulf Coast, which could help bring WTI prices closer to Brent prices as it facilitates the flow of oil out of Cushing, where WTI crude oil is priced.

2013.12.23 - WTI-Brent STEnlarge Graph

 

Background: The WTI-Brent spread over 2013

WTI had been trading as low as $23 per barrel under Brent in February of 2013. Over the course of the year, the spread narrowed due to several factors. Firstly, increased midstream infrastructure has come online facilitating the movement of crude from inland to refiners on the coast. One notable example is the expansion of the Seaway Pipeline in January 2013, which allows more crude to flow from the Oklahoma crude hub at Cushing to the Gulf Coast, where a great amount of refining capacity sits. Additionally, Sunoco’s Permian Express Pipeline and the reversal of Magellan Midstream Partners’ Longhorn Pipeline are allowing more crude from the Permian Basin in West Texas to flow directly to the Gulf Coast. Furthermore, increased pipeline capacity and crude transportation by rail have allowed inland domestic crude to more efficiently travel to refiners on the East and West coasts, which has also backed out Brent-like imports.

Lastly, US refineries began running at higher rates earlier in the year, which caused increased demand for crude. Since spring 2013, many US refineries started to come back online from performing routine maintenance, and the EIA reported that in July domestic refineries were running crude through their facilities at a rate of ~16.3 million barrels per day through June 2013. This is a ~2.1 million barrel a day increase over the first week of March. Furthermore, new refining capacity opened up in the Gulf Coast, helping increase refiners’ demand for crude.

So the spread between WTI and Brent closed in through the year until the two crudes traded nearly at par in mid-July. In late August and early September the spread widened to nearly $8 per barrel. This was partly because supply from Libya had dropped sharply due to unrest. Additionally, the escalation of tensions in Syria had caused traders to take bullish bets on the international oil benchmark of Brent crude and has also possibly driven the price differential between WTI and Brent. Since then, fears about Syria eased somewhat and production from Libya started to recover so that spreads closed in again to ~$3 per barrel in mid-September.

After that, data continued to show growing US crude production particularly from areas such as the Bakken in North Dakota and the Permian in West Texas. Accompanying the crude production growth were increasing stocks of crude inventories, particularly at Cushing, a major crude hub in Oklahoma. Cushing inventories have risen for seven weeks straight, after several months of steep declines. This is a signal that inland crude production flowing into Cushing may be starting to overtake the existing takeaway capacity, which would have the effect of depressing WTI crude oil prices in comparison to Brent prices. During this period, the spread gradually widened to levels as wide as ~$19 per barrel in late November, before closing into current levels of ~$13 per barrel. The recent narrowing was partially driven by the news of the imminent opening of the southern portion of TransCanada’s Keystone XL pipeline, and stabilization of tensions in the Middle East.

The spread’s effect on oil companies

When WTI trades below Brent, this generally means that companies with oil production concentrated in the United States will realize lower prices compared to their international counterparts as WTI is the de facto US benchmark and Brent is the international benchmark.

For example, see the table below for a comparison of oil prices realized by U.S.-concentrated companies versus companies with a global production profile.

3Q13 Average Price Per Barrel
BENCHMARK OIL PRICES
West Texas Intermediate $109.65
Brent $102.44
3Q13 Realized Oil Prices Per Barrel (excluding hedge gains/losses)
DOMESTIC PRODUCERS
Chesapeake Energy (CHK) $101.08
Concho Resources (CXO) $102.10
Range Resources (RRC) $91.82
Oasis Petroleum (OAS) $100.75
INTERNATIONAL PRODUCERS
Total Corp. (TOT) $107.20
ConocoPhillips (COP) $106.60

From an investment point of view, if Brent is expected to continue to trade significantly above WTI, one might favor buying oil names that receive crude prices closer to the Brent benchmark than the WTI benchmark. Generally speaking, this would represent oil names with more international production relative to domestic (US) production.

Investors may want to monitor the spread, as a wider spread may make international producers more attractive relative to domestic producers. The difference between Brent and WTI has caused domestic producers such as those ones mentioned in the above table (CHK, CXO, RRC, and OAS) to realize lower prices on oil compared to international producers. But over the medium term, the spread has closed dramatically and now signals better takeaway capacity for inland U.S. oil. Investors should note that many international names are in the XLE ETF (SPDR Energy Select Sector), an ETF (exchange-traded fund) whose holdings are primarily large-cap energy stocks with significant international exposure. In comparison, the XOP ETF (SPDR Oil & Gas Exploration & Production ETF) is weighted towards domestic-only names.

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