The WTI-Brent Spread: narrowing in the New Year?

UPDATE: For more on the WTI-Brent spread check this updated article "Seaway no Solution" as well as a discussion of 2013 forecasts here.

The WTI-Brent spread describes the relationship between the two most widely used benchmarks for crude oil prices. While the oil represented by each benchmark is similar, WTI has historically fetched a slightly higher price for a number of technical, economic and geographical reasons.  While being similar grades of light, sweet oil, WTI has preferable sulfur content and is better for producing gasoline than Brent. Furthermore with the USA being a large importer of oil, the total price paid to import Brent, that is the cost of the oil and the delivery costs, should roughly reflect the total price of domestically produced WTI, all other things being equal. Hence when factoring out these higher delivery costs from the North Sea region, Brent has tended to fetch a slightly lower price.

Despite these factors, Brent currently fetches a massive premium of around $22 per barrel over WTI, and as the chart below from yCharts shows, this is near a record high. So what are the reasons for this recent disparity, and what’s more where should we expect this relationship to go over the short-medium term?

Brent WTI Spread data by YCharts

Let’s begin with a bit of background information on the difference contracts: due to the physical nature of oil transactions, each contract must have a delivery point. For Brent it can be anywhere in Europe, but for WTI it must currently be Cushing, Oklahoma. This is an important factor in the pricing of WTI; as Jim Brown of Oil Slick explains,  if there are logistical problems such as excess demand for storage at Cushing, the price of WTI will decline as the cost of opportunities for traders, such as buying and storing WTI for future sale, increases.  With this increased supply glut at Cushing it is also harder for traders to take advantage of short-term opportunities as there is more competition for pipeline capacity and therefore the oil takes longer to move. These factors are all currently at play, and hence the price of WTI is being driven down.

While there are factors that are driving down the WTI price, there are also factors that are driving up the Brent price and thus causing the spread to widen. With Brent the international benchmark for much of Middle-Eastern produced oil, increased risk in these regions drives up the chance that less Brent-benchmarked oil will be available in the future and that current contracts may not be delivered. This increased risk is represented in the total Brent price as a risk premium, and the risk premium has increased greatly since early 2011 due to a number of factors such as the Arab Spring uprisings and continuing political turmoil in the Middle Eastern region. This is clear if you cross-examine this Guardian-provided timeline of these events against the spread chart from Ycharts; we see that the spread spiked as events associated with the uprisings began in January 2011 and further spikes coincided with events such as a intensifying of fighting in major oil producers such as Libya in September 2011, shortly before the death of Colonel Gaddafi in October 2011, after which the spread began to fall as sentiment improved.

In 2012 risks to the Brent supply have continued with events such as the civil war in Syria threatening oil supply routes as well as other recent events that have caused the Brent price to spike; for instance trade sanctions on Iran have reduced potential supply and there have been a much higher occurrence of unplanned oil field outages in the North Sea than normal during this time of year.

The question that is of interest to us is where the WTI-Brent spread is heading, and while it is hard to predict political events that influence the risk premium of Brent, there are at least a number of factors that should mean the price of WTI will begin to rise and converge to the Brent price minus it’s associated risk premium, therefore creating a WTI-Brent spread trading opportunity. As Sandy Fielden of RBN energy explains in this article, the major Seaway oil pipeline between Cushing and Houston, which historically has flowed toward Cushing, is being reversed and expanded to allow 400,000 barrels of oil per day (mb/d) to flow away from the supply glut and towards refiners on the Gulf Coast, with an estimated completion date begin early 2013. Furthermore from mid-2013 an upgrade at the BP Whiting refinery in Indiana should be complete and will add around 400,000 to oil demand in the area. In addition to these factors a number of rail upgrades throughout 2013 will continue to alleviate the supply glut at Cushing and therefore reduce the rate at which supply is currently outstripping demand. Many analysts thus predict a narrowing of the WTI spread.

While there are a number of reasons why we may expect the WTI-Brent to narrow in 2013, we should also be aware of the structural changes in the global economy which may mean the spread may not revert to its previous position in which WTI commanded a slight premium. As mentioned in my previous post, “The long-term relationship between the US dollar and oil prices” (LINK), the macroeconomic structure of the global economy is changing and the USA will in the future account for less of the total oil demand than it has done historically. As mentioned above, part of the reason for a WTI premium is the delivery cost of Brent to the USA. If instead Eastern economies such as India and China begin to outstrip the USA’s oil demand, then it could be that WTI will trade at a lower price due to higher delivery costs to these emerging economies. If the current political rivalry between these emerging economies and the USA continues, it is also possible that trade sanctions and the political charge for energy independence in the US will mean US exporters will not be permitted to export to these economies, and thus WTI will in effect face a different demand market than its European counterpart, with different price implications attached. 

Overall trade idea: shorting a medium-term Brent contract while going long on the associated WTI contract will give investors exposure to the factors that influence the spread while hedging against movements based on macroeconomic fundamentals. As of end of trading 19/12/2012, Brent is priced at  $110.16 while WTI is at $89.69 we'll revisit these in the new year to track the progress of a virtual trade on this spread.