<

Must-know: Why did commodities trade so mixed last week?

Part 4
Must-know: Why did commodities trade so mixed last week? (Part 4 of 4)

Why analysts forecast an $11-per-barrel WTI-Brent oil spread

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 representing the price U.S. oil producers receive and Brent more representing the prices received internationally. The two crude oils are of similar quality and theoretically should price very closely 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.

2014.02.15-WTI Brent Crude Oil SpreadEnlarge Graph

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

WTI-Brent spread traded narrower last week

The spread between WTI and Brent crudes closed at $8.81 per barrel on February 14, compared to the previous week’s spread of $9.42 per barrel. Last week, WTI prices rose by $0.42 per barrel, while Brent traded down by $0.49 per barrel—from $109.57 to $109.08. Consequently, the WTI-Brent spread traded slightly narrower on the week.

The EIA expects a wider average spread

The U.S. Energy Information Association in its latest “Short Term Energy Outlook” report noted that it expects the spread between WTI and Brent to average $11.46 per barrel over 2014 and $11.34 per barrel over 2015—slightly higher than current levels. The forecast takes into account increasing uncertainty for existing refinery infrastructure to process an increase in light sweet crude production in North America, pushing WTI prices down relative to Brent. The EIA stated that its forecast reflects “the economics of transporting and processing the growing production of light sweet crude oil in U.S. and Canadian refineries.”

2014.02.15-WTI Brent Crude Oil DifferentialEnlarge 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. Plus, 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. 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. For more information on the latest pipeline development, please see Why the new Keystone XL pipeline helps narrow the WTI-Brent spread.

U.S. refineries began running at higher rates earlier in 2013, which caused increased demand for crude oil. Since spring 2013, many U.S. refineries started to come back online from performing routine maintenance. The EIA reported that in July, domestic refineries were running crude oil 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. Plus, new refining capacity opened up in the Gulf Coast, helping increase refiners’ demand for crude.

So the spread between WTI and Brent closed in throughout the year, until the two crude oils 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. Plus, the escalation of tensions in Syria had caused traders to take bullish bets on the international oil benchmark of Brent crude and perhaps also drove 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 U.S. crude oil 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. During 4Q 13, Cushing inventories rose for seven weeks straight after several months of steep declines. This was a signal that inland crude production flowing into Cushing may have started to overtake the existing takeaway capacity, which would have depressed WTI crude oil prices compared to Brent prices. During this period, the spread gradually widened to levels as wide as ~$19 per barrel in late November before closing 2013 at ~$12 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 stabilizing tensions in the Middle East.

The spread’s effect on oil companies

When WTI trades below Brent, this generally means companies with oil production concentrated in the United States will realize lower prices compared to their international counterparts, as WTI is the de facto U.S. 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, investors might favor buying oil names that receive crude prices closer to the Brent benchmark than the WTI benchmark. Generally, this would represent oil names with more international production relative to domestic (U.S.) 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 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 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.

The Realist Discussions