Brent-WTI Spread Update: On a Path to Convergence?

The WTI-Brent spread has been big news for traders since the beginning of the year, and the spread has cycled in an $11.8 range since January 1st. As the chart below shows, the premium started the year at $19.4, fell as low as $15.5 in mid-January and then rose back up to $23.2 in early February. Since then the spread has dropped dramatically, falling by $9.4 since March 5th, closing on Friday at $11.4. The question is what’s caused this reversal in the last few weeks? And will Brent’s premium over the US blend continue to fall?

A variety of factors have been behind the recent narrowing of the Brent-WTI spread. Firstly a look at Brent: The North Sea grade was priced at $118 in mid-February, but the price has since dropped to $104.1. Yet there has been only slight signs that economic growth may not be as strong as it was considered back then, which if anything could actually rise the expectation of monetary easing programs and thus go to increasing commodity prices. So what has caused this $14 drop? Supply fundamentals have been one reason; production that had been curtailed due to a pipeline leak has come back on-line, while some smaller fields are also planning crude deliveries in April, from none in March. In fact, North Sea output will be 15% higher this month than March; hence supply on the spot market is particularly loose.

Seasonal refinery maintenance programs in Europe and other continents have also reduced demand for the North Sea blend, while demand has also been affected by a potential South Korean decision to close a tax loophole that had previously allowed refiners in that country to claim a $3 tax rebate on each barrel of Brent crude, despite not actually paying the tax due to a free-trade agreement with European countries. The rebate, which came into effect in 2011, had resulted in an eightfold increase in South Korean crude imports from Britain last year to an average of 70,000 b/d. But the potential change in tax law, which was announced early last month, resulted in a fall in ships transporting oil to Korea.

Apart from the changing demand and supply fundamentals, the geopolitical risk premium built into the Brent price has also dropped, particularly with regard to the situation in Iran. BCA Research published a great graph at the end of March showing how the price of Brent deviates from a fair-value model they have in correlation with the level of Iran references on Google, such as news events. Indeed price deviations seemed to spike with these references and then fall in a lag, which would explain the fall in prices seen in the last week relative to WTI.  The borrowed-graph from the article is below.

It’s not just Brent’s fundamental situation that is changing. The supply infrastructure for US crude, with WTI as the main benchmark, has been rapidly changing this year as more and more crude is taken by road and rail in an attempt to relieve the supply gluts that had formed at various points in the supply chain, particularly Cushing where the benchmark price is set. These alternatives to pipeline transportation are expected to grow this year; for instance Warren Buffet’s Burlington Northern Santa Fe railroad company expects crude transport to increase 40% this year. Media also reported that Crude was being trucked out of Cushing all the way to the Gulf Coast, a method that can cost up to $20 a barrel. The start-up of the reversed Longhorn pipeline from the West-Texas Permian basin in March also resulted in crude being taken off the route that flows through Cushing, thereby reducing pressure at the price-forming point. The pipeline has to be injected with an initial 900,000 barrels of oil before flow can start, which itself thereby serves as a sort of storage.

All of these infrastructure changes are taking place at a time when US refineries typically ramp-up production in anticipation of the US summer season, when gasoline in particular is of higher demand and when the quality of the fuel has to be higher as well. Crude imports have also been phased out as more of the domestic crude becomes accessible to refiners, particularly to the gulf coast which has seen more and more domestic crude delivered to the region. Rail connections are also enabling East-Coast refineries, which typically import all of their crude input, to start taking some of the US-produced oil and thus limit supply gluts elsewhere in the country. As such demand for WTI has been increasing and demand for Brent has fallen.

The future for the Brent-WTI premium

Based on the current looseness of the Brent supply situation and a lull in the risk-premium that the grade has been experiencing in the last few months, I actually expect the main risk over the next couple of months to be that the Brent-WTI spread will widen, despite the continuing trend of narrowing. The US remains extremely well supplied, and while some new pipeline infrastructure will take some of the pressure off supply gluts in the Mid-West, these will simply be transferred to the Gulf Coast where more storage is available, but where many of the refineries are not actually set up to refine light sweet oil such as WTI. Brent meanwhile will likely find some strength over the coming weeks as refinery production ramps up and China may take advantage of prices that are $14 lower than their recent peak to replenish supplies. What’s more, the South Korean tax decision has been delayed for a further three months until July, which will support Brent prices.

Having said this, based on better mobility of US crude from rail and road, as well as increased demand from refineries, can we expect the Brent-WTI premium to move back down to zero towards the back of the year? The answer is no, this level of convergence will not be seen for a few years at least. In fact it’s important to note that despite improvements in mobility, the spread between Brent and WTI needs to remain at a level which continues to make rail movements profitable. Given the cost of transporting oil from Bakken in North Dakota to the East Coast is about $15, and that Bakken oil currently trades at around parity to WTI, we shouldn’t expect a fall in the Brent-WTI premium to much below its current level to be sustainable. In terms of other analyst’s forecasts, recent releases show that Societe General expects an average spread of $16 this year, and Morgan Stanley expects a spread of 14.50. Given this year’s current average is $17.7 so far, these forecasts imply the spread will average $15.4 and $13.4 over the remaining 9 months. I would say the latter seems more likely unless we see a re-ignition of the geopolitical risk premium.