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.

Brent-WTI Spread: Condensates Causing Problems

As I’ve mentioned in my previous two articles on the Brent-WTI spread (Narrowing in the New Year? and Seaway No Solution), US domestic crude production has grown rapidly over 2012 and is expected to continue increasing this year. What’s more, a large amount of this crude is ultra-light oil known as condensate. This oil is the opposite specification of the heavy crude that the majority of US gulf refiners are set up to process and so currently US condensate demand is low, and the increased storage needs alongside regular WTI crude is leading to the prices of both falling relative to Brent.

While current export laws prevent oil companies exporting condensate despite low domestic demand, Bloomberg report that some companies are now setting up so-called mini-refineries that will use a simple process to distill the condensate into separate fluids in order to meet permitted export conditions for products made from raw crude.

The mini-refiners or “splitters” should be able to process 300,000 b/d each, with the first production expected to start in 2014. On top of this this the US Commerce Department is approving more export licenses for raw-condensate to international oil companies that process the ultra-light oil in other counties, such as Valero’s refinery in Canada. With each permit granted on its own merit, such a process takes time and as Keith Shaefer of the Oil and Gas bulletin explains, condensate production is increasing at a faster rate than new agreements and refineries are established. Thus while these developments are good news for US oil prices in the long term, they’re unlikely to affect the Brent-WTI spread this year.

Those who are interested in learning more about condensates should check out RBN Energy’s three great articles on the subject; Fifty Shades Lighter – What Should Be Done With Condensates?, Fifty Shades of Condensate – Which One Did You Mean? And Fifty Shades Lighter – The Lease Condensate Export Problem.

WTI-Brent Oil Price Spread: Seaway No Solution

Back in December, I suggested that the Brent-WTI spread would likely narrow in the New Year due to the completion of the key Seaway pipeline as well as increases in refinery demand. Back then, the spread was at $22.6 and indeed narrowed considerably to reach $15.6 on 17^th January. Since then however, operators of the Seaway Pipeline have announced that flow has been restricted due to new bottlenecks building up at the delivery point in Texas, and markets have come to realise that not only is Seaway not the miracle cure to the inventory build-up, but that the key factor affecting the Brent-WTI spread may not be logistics, but rather overwhelming supply. In the wake of these realisations, the spread has more than reversed, closing at $21.8 on Friday as the chart shows.

The announcement from Seaway came on January 23^rd, when Enterprise announced storage at the final terminal in Jones Creek, TX, had reached full capacity and thus no more crude could flow into the terminal. The reason for this is that the terminal has just two outlets; a further pipeline to Texas City and Phillip 66’s Sweeny refinery. With the refinery under maintenance, demand from Jones Creek was reduced by up to 247,000 b/d, and the 2.6 Mb available in storage was not enough to absorb the surplus supply.

While the Brent-WTI spread widened significantly on the news, many analysts still expect a narrowing of the spread in the coming quarters because of additional infrastructure projects that are coming online. The range of these estimates varies widely; Goldman Sachs expects a spread of $7.50 in Q2, while the writers at Econblog believe $12 would be more realistic and analysts at Deutsch Bank don’t expect the spread to narrow until the second half of 2013. To understand the reasoning behind these differing forecasts, let’s take a look at some of the additional projects that will help change the current structure of the US crude market.

Pipeline from Jones Creek to ECHO

The first project should complete Seaway’s original purpose of moving crude from Cushing to a place of greater demand and greater storage capacity. Enterprise are currently in the process of building a lateral pipeline between Jones Creek and Enterprise’s crude storage terminal in Houston, called ECHO. The terminal, which currently has a storage capacity of 750,000 barrels (that will someday be 6 mbls), is connected to refiners in the Texas Gulf area with a total refining capacity of 3.8 Mb/d, as well as having water access to move crude to other refineries on the Gulf coast. Furthermore, with NYMEX considering implementing a new benchmark for US crude at the ECHO terminal, Enterprise will be doing all they can to ensure the terminal features as a major future hub no matter what the structure of the oil market. Given this, additional pipelines out of the terminal are already planned; by 2014 there should be a pipeline connecting ECHO to the 1.84 million bbls Beaumont/Port Arthur refinery complex.

Enterprise and its customers are confident this lateral connection is what the oil supply chain needs; earlier this month transporters provided the long-term commitment needed for the company to build a twin Seaway Pipeline, which is expected to increase total capacity to 950,000 b/d by 1Q2014 from the current 450,000 b/d.

While the market has had Seaway tunnel-vision in the past month, focus has also moved on to other projects expected to relieve the glut at Cushing. One of the reasons cited by Goldman Sachs’ Jeffrey Currie for his belief that the spread will fall to $7.50 is the implementation of Magellan’s Longhorn pipeline reversal, allowing an initial 75,000 b/d flow from the WTI producing Permian basin to Houston in Q1, expanding to 150,000 in Q2 and eventually 225,000 b/d.  Additionally Sunoco Logistics is also implementing a reversal of two pipelines which will take crude from the Permian basin area to the Gulf coast, with an eventual capacity of around 200,000 b/d. The combined changes  mean at least 280,000 barrels can avoid Cushing in Q2.

Another project to reduce the crude flow through Cushing is a major expansion to the Keystone pipeline, which currently runs from Canada to Cushing through an indirect route, but will soon allow a direct route from Canada to Texas and thereby providing another route for crude flows out of Cushing. On the flip-side, this will also mean much more crude in the Gulf area.

It’s not just pipelines that will transport extra production; Rail is now the preferred transportation method from oil plays in North Dakota. The total amount of crude carried on railways in the US is 350,000 b/d and the main carrier, Burlington Northern, expects the 240,000 b/d it transported in 2012 to increase by 40% this year. Much of this will be to refiners on the Gulf coast.  

While these pipelines will help reduce the glut at Cushing, they will only be effective in decreasing the Brent-WTi spread if excess crude in the Houston area can find its way to points of demand. The reversal of Shell’s Houston to Houma, LA, pipeline should also be finished by Q1/Q2. This pipeline, with a capacity of 250-350,000 b/d will allow crude to flow from Houston to the Louisiana Gulf refinery area in which there is a potential 3.2 MMb/d of refining capacity.

Will there be enough crude demand?

While there are plenty of projects that will help alleviate various bottlenecks in the oil supply chain, none of these will actually increase the price of oil if demand at the final destination is overwhelmed by the new supply. However with different refiners set up to process different types of crude, it’s not just a case of total crude supplied matching total crude demand. Indeed, with the boom in tight oil coming only recently, refiners have actually spent the last few years investing to process heavy crude rather than domestic light crude. Furthermore the country cannot just export excess light crude in return for heavy imports, as the US limits exports for political reasons. With the current administration unlikely to permit increases in outright exports before the country reaches its energy self-sufficiency targets, US produced crude prices would have to fall before the government acquires the political mandate to allow exports, or before refiners have the incentive to convert back to processing light crude.

Will the spread narrow this year?

Seaway tunnel-vision reined in the market earlier this year, and the consequences of such a view is that many have been hurt on bets on the Brent-WTI narrowing that didn’t materalise. There are now three main camps with regard to the Brent-WTI spread; those who believe the spread will narrow in Q2, those who believe it will not narrow until later this year or 2014, and those who don’t believe it will narrow at all, and that WTI pricing will be completely overwhelmed by excess supply.

Given the current outlook, it looks as if a combination of these views will prevail; a narrowing of the spread in Q2 and 2H followed by a widening again in 2014. In this process, WTI will see gains as infrastructure comes online which will result in sweet crude imports being priced out and the WTI-Brent spread will narrow. However as US production increases, storage will fill up and bottlenecks will be seen in weak points of the supply chain, which would result in the Brent and WTI again beginning to diverge. It’s likely this process will be more gradual than the rapid narrowing seen at the beginning of January, as those burnt from the reversal take more caution.

One of two things would then have to happen to prevent the wide spread remaining; a reversal of export policy or refiners switching to processing light crude. Due to the political attractiveness of energy independence, a change in export policy would have to have clear benefits for the US economy which means the administration may have to wait for prices to fall before it gains support. The same applies to the refinery conversion process; sweet crude prices need to be sustainably lower than imported heavy crude for the capital expenditure to be justified. Both of these things will take some time, and thus the spread is likely to widen further before complete price convergence between WTI and Brent is achieved.

Weekly Crude and WTI Oil Market Summary: European woes spook oil markets

11^th – 15^th February

A combination of an early-week price correction and euro-area economic woes meant Brent failed to get near the $120 mark that was thrown about at the end of last week. Rather, the grade experienced its first weekly loss in five weeks, falling 1% to close on Friday at $117.7. While WTI prices increased 0.2%, gains were significantly pared by economic factors as well as a bearish EIA release that showed a large rise in US crude production. Despite this, the Brent-WTI spread fell by $1.4 from the previous week’s close to reach $21.8.

Weekly Summary

Brent gapped down by $1.1 to open on Monday at $117.8. The grade continued to fall -0.5% on the day, despite possible risk related pressure increasing after Iran’s president Ahmadinejad said on Sunday that the country would not stop its nuclear development despite sanctions. The fall in Brent looks to have been a price correction, with the upcoming $120 mark representing a significant line of resistance that some investors are not certain Brent will break through. WTI meanwhile experienced a solid 1.3% increase on the day to finish at $97, despite at one point falling from the $95.8 open to $95. While continued positive sentiment from last Friday may have been a factor in the increase, with no significant market news herd mentality may have been at play after Goldman’s Jeffrey Currie reiterated the belief that the Brent-WTI spread would narrow to $7.50 in Q2. Thus with some speculating that Brent could increase up to $130 this year, WTI would have a lot of catching up to do. Historically however, the global head of commodities at Goldman has been notoriously bad at forecasting spreads as Econmatters reports.

Both the EIA and OPEC increased their forecasts for 2013 global oil demand on Tuesday, with the resulting positive sentiment leading to gains in WTI of 0.6% and of 0.4% in Brent. Despite rising demand, OPEC’s forecasts still indicate a surplus OPEC-production of 540,000 b/d, indicating the cartel’s main producer Saudi Arabia may continue to reduce production over the coming months. These positive demand signals were somewhat supported by further risk awareness, with North Korea reminding the world of its nuclear capability in an underground test. The late-night release of the API American crude inventories showed stocks had fallen -2.3 MB, which provided some support to end-of-day US trading.

Wednesday’s trading started off on a negative note as the International Energy Agency contrasted the previous day’s demand forecasts with a bearish release. While negative sentiment from this release was offset by a positive euro-area industrial production release, showing the highest growth since August, a bearish EIA inventory release resulted in an overall negative day for WTI. The breakdown, which showed US domestic production accelerating, led to further fears of supply gluts in the country and WTI fell -0.6% on the news. The more internationally traded Brent managed a 0.2% rise.  For more on the EIA release check-out my previous post: Weekly WTI Crude Oil Inventory Analysis.

Trading on Thursday also started with bearish tones, with downbeat GDP numbers for the euro area at -0.6% q/q showing the worst decline since 2009. While markets are used to negative sentiment originating from the euro-area, the fact that France and in particular Germany fared worse than expected was particularly bad news. Growth data from Japan also came out as negative, although the fact that this helps justify the country’s current monetary stimulus may in fact benefit prices in a similar counter-intuitive nature seen in the past years in the US. Despite the negative European news, a combination of positive jobs news in the US and a lack of progress in intentional talks in Tehran provided a cushion for prices, and at close of trading WTI and Brent were both up 0.1%.

A variety of negative economic news combined to result in price falls for both grades on Friday, with a fall in euro area exports further confounding negative sentiment from the GDP release, while in the US industrial production also fell. Equities, of which oil at the moment is closely correlated, also suffered as internal communications from Wal-Mart showed a big hit to retail sales in February, prompting fears that consumption has been badly hit by increased payroll taxes. WTI was hit hardest by the news, falling -1.4% to close at $95.9, while Brent ended the day -0.3% down at $117.7.

Week Ahead

Signs were finally seen that Brent may not be on a unstoppable upward trend this week, but it remains to be seen whether the drop in prices represents a peak, or whether it is simply a short-term technical retracement. While the risk premium plays a large part in the Brent price, an absence of any major geopolitical events means a breach above $120 will only come if economic data exceeds expectations this week.

China announced yesterday a slowing of the growth rate of retail sales for last week, but this has been put down to a government crackdown on corruption and indeed the main loss of sales was seen in hospitality industry, with goods consumption growing significantly. This may provide positive momentum for oil at the Monday open in Europe, while US markets will be closed for President’s day. If such momentum does appear, then WTI would increase substantially before Tuesday’s close providing the release of the US housing index at 10:00 ET shows a continuation of the upward trend that stalled last month; so far the consensus in markets is that this will indeed happen. 

Brent and WTI crude oil price forecasts: 2013 Summary and Projections

Whether you are a short-term trader or long term investor, it’s good to have an idea of where markets could be heading and what events will be the key drivers of market change. Hence in this article I’ll be looking at the possible determinants of oil prices in the remaining 11 months of 2013 and take a look to see where analysts are predicting oil prices will head over the year.

Current Forecasts

Analysts generally forecast prices a couple of years out, but given the large number of unpredictable events that affect macroeconomics and politics, these forecasts often change. The table below demonstrates these changes, showing that forecasts of the 2013 Brent price by analysts polled by Reuters fluctuated up and down over the second half of the year, with the average prediction now standing at $109.7, $3.70 down from the current price of $113.50. Given this is an annual projection, it means most analysts predict prices will fall below $109.7 at some point.

	Mean forecast
Aug-12	$107.2
Sep-12	$106.9
Oct-12	$108.8
Nov-12	$107.5
Dec-12	$108.0
Jan-13	$109.7

What should you make of these forecasts, and how have they been formed? Given the average yearly price is forecast to be less than the current prices, let’s begin with a look at what could cause a fall in Brent and WTI prices.

Booming US production

EIA data show US oil production has been accelerating a record rate, and the increase in production last year outstripped the growth in pipeline capacity, causing the much talked about supply glut at Cushing, Ok and leading to the capacity upgrade and reversal of a pipeline that previously flowed into Cushing. As the graph below shows, production has increased from around 5 mbd to 7 mbd in the last 5 years, with the majority of this growth coming in 2012, when production increased around 14% y/y from Jan-Nov compared to 2011. With EIA expecting US production to continue to grow by another 0.9 mb/d in 2013 (Table 1, an increase of 14%) we could see downward pressure on WTI due to increased supply as well as downward pressure on Brent due to decreased US demand for imports. Such developments are already being noticed; last week Hess announced a closing of a New Jersey refinery that still relied on Brent imports due to increased costs of the North Sea blend versus the WTI blend, which should reduce import demand. This is combined with the fact we have already seen US crude oil imports decreasing in the last few months. Furthermore, in an announcement last week Seaway pipeline operators Enterprise confirmed that the increased capacity was unable to be utilized to full effect due to new bottlenecks in supply in Texas, with these not expected to be alleviated until 2H2013. Thus if increased US production does arise then a lot of this is unlikely to be able to reach refineries and thus increased storage costs will weigh on the price

Other non-OPEC production is expected to rise

The EIA also expects large gains in crude production in other non-OPEC countries, with the agency forecasting total non-OPEC crude and liquid fuels supplies to rise by 1.42 mb/d to 53.89 in 2013. Accounting for the US, this means there should be growth of around 0.5 mb/d a day in other non-OPEC countries, with potential sources of growth including South Sudan, Brazil and Kazakhstan. South Sudan would be the area where supplies could come on-line the soonest, with the current lack of supply a result of a dispute between South Sudan and Sudan over how much the Southern country should have to pay to transport oil through pipelines in the North. If solutions are found and production reaches the pre-shutdown rate there would be an extra 350,000 bd on the market.  Elsewhere, Kazakhstan’s new oilfield Kashagan is expected to reach 150,000 bd by the middle of the year. However as the FT reports, projects in Kazakstahn have been beset with problems and even reaching 150,000 bd would be a success at this stage.

In September the EIA suggested Brazil’s output could grow by up to 200,000 b/d in 2013 due to its offshore, pre-salt fields which could contain reserves equal to those found in the North Sea. Production growth has been slow however due to strict legislation by the Brazilian government aimed at ensuring Brazil gets its fair share of the profits. This included the halting of production & exploration licenses in 2008, resulting in foreign companies having to take the slow process of merging with companies already in possession of licenses in order to gain opportunities for growth. A long awaited auction is now scheduled for May and could result in further Brazilian developments in the second half of 2013, although these issues demonstrate that there may not be considerable Brazilian growth this year.

Upside Risks

While increased production remains the significant downside risk for crude prices, there are a number of factors that could result in crude prices continuing to rise after already increasing in January. These include:

A higher risk premium from geopolitical tensions

The current risk-premium priced into Brent is believed to be between $10-$20. While this premium could rise or fall, there are a number of issues concerning the Middle East and Africa that could add a further premium; this article at oilprice.com provides a narrow summary. This list is not exhaustive however, and a potentially huge problem would be a further breakdown in relations between the Kurdish regional government and the Iraqi central government over long-running tensions that have been further fueled by the regional government signing independent contracts with international oil companies, eager to secure additional supply in the face of high prices. Currently the central government is threatening to withdraw fiscal payments to the area, and readers who want to learn more on this issues should see this Time article as a great starting point, as well as this article at Foreign Policy in Focus for further information.

At the top of the risk-premium agenda will be continued issues between Iran and the Western international community, with current sanctions against Iran reducing exports from 2.2 to 1.4 mb/d according to Reuters. There has been much speculation that military action by Israel against nuclear facilities could be possible, and one of Iran’s main tactical advantages is controlling the Strait of Hormuz, which carries 17.5 mbd of oil supplies from the Middle East to Europe and beyond. While other avenues for crude out of the region exist and are being developed further, the current situation has resulted in Iran threatening to close the Strait in the event of military intervention, and US threatening intervention only if Iran closes the Strait. The problem here would be antagonistic action by other countries such as Israel in the belief that this would push the US to get involved. Today the country did announce it will be meeting directly with the US on February 25^th, so this is the next date to look out for.

Saudi Arabia will cut production

With many members of OPEC counting on oil revenues to fund their budgets, the cartel has tended to keep a minimum Brent price floor. For the first half of 2012 this was thought to be $100, however at a June meeting OPEC communicated that this could comfortably rise to $110 without damaging global growth, and reaffirmed this at the latest meeting in December . While the cartel confirmed that it would maintain a production ceiling of 30 mb/d, about 1 mb/d above its production at the time, the group also said it believed demand for its oil would fall to 29.7 mb/d in 2013 and data released in early January show Saudi Arabia had actually already began reducing their output in December. Although there have been suggestions that this could just be due to seasonal demand issues.

Economic growth in the US and China will accelerate

The effect of macroeconomic expectations for the USA on oil prices was demonstrated over the New Years when politicians voted to avert the so-called fiscal cliff on December 31^st, resulting in the WTI price increasing 3% over the two days of trading on 31^st December and 2^nd January. Given that the last few weeks have seen a number of economic indicators and corporate earnings in both the US and China come in better than expected, many market commentators are now suggesting this could finally be a return to something like pre-crisis growth levels, and thus oil prices would come under further pressure from increased demand.

Oil will increase in line with US equities

This point relates indirectly to above, but argues that potential negative supply factors will be overwhelmed by oils increasing position as an investment asset. As the EIA reports here, correlations between oil and other factors have become increasingly stronger. In particular, since 2008 oil has shown an increasing correlation with US equities and inflation expectations as well as a negative correlation with the USD. Some believe this is because oil is increasingly being seen as an investment asset; hence if equities are rising on economic expectations then oil demand is expected to increase and investment in oil contracts increase too. A negative correlation is seen with the USD as a weaker dollar makes oil cheaper for non-US investors, as well as raising inflation expectations in the US which causes investors there to seek assets that will increase with inflation such as commodities.

Summary and Forecast

With the announcement last week that the Seaway Pipeline has not been able to operate effectively due to storage capacity constraints, I do not see how WTI prices can continue to increase in the first half of the year, particularly if US production does grow as much as analysts are expecting. While I expect prices to rise in the second half of the year on the back of growth and the completion of further storage infrastructure, I nevertheless expect a slight decrease in the average WTI price from what it is now, to somewhere in the $90-$95 range.

For Brent the situation is a bit more tricky. If the geopolitical risk premium remained the same, I would expect at least that the Brent price would not fall much from its current level as global growth offsets some increase in supply, which would also be balanced out by less Saudi production. Having said that, it’s highly unlikely that the risk premium will not change when we have upcoming events in February regarding Iran to look out for. My view would be that the price could fall if these issues look positive, resulting in an average 2013 Brent price of $110 - $115.

Lastly it’s important to remember that prices of any asset class or commodity are difficult to forecast, with oil notably difficult due to the myriad of events that can affect both demand and supply. For an interesting article on how analyst’s forecasts have performed historically, check out this article at risk.net.

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.

The long-term relationship between the US dollar and oil prices

Bloomberg published an interesting article yesterday stating that the USD is expected to appreciate in the future given the US shale oil production boom that could make the US a net oil exporter by 2020. While higher US production will have an impact on global oil markets, how could a strong USD also impact? http://www.bloomberg.com/news/2012-12-17/fracking-boom-is-dollar-boon-in-energy-independence-currencies.html

Firstly let’s look at the current relationship between oil and the USD. At the moment the US is a net oil importer, this means that there is a USD outflow to oil producers such as the OPEC nations. These countries seek to invest this income in a portfolio of assets which are not all priced in USD and hence to make these investments USD must be exchanged for other currencies. This means that as more oil is imported, more USD flows on to currency markets and the USD will depreciate due to laws of supply and demand. With a higher domestic oil output this process should reduce or even reverse, and so the USD is expected to appreciate.

To answer how this stronger USD could impact oil markets, we can look at what the effects of a weaker USD, caused by QE during the crisis, were expected to have on the price of oil. A 2011 article by Reuters  thought that for two main reasons this would case a rise in the oil price. Firstly, oil purchases would become more attractive for holders of other currencies, which results in higher demand for purchases. Secondly, because producers of oil receive USD for their exports, a weaker USD can cause these producers to reduce supply to drive up the oil price such that in terms of their domestic currency their export income remains the same. While OPEC producers have in fact kept supply strong, this has been due to their belief that a higher price could endanger an economic recovery and therefore their future earnings.

So if a weaker USD results in a higher oil price, can we for the same reason expect a stronger USD to result in a lower oil price? Well, in terms of the action producers take, they may be keen to maintain a certain level of income, but it is unlikely they would take action to prevent a higher level of income. The exception to this rule is if they believe a high oil price for non-US countries could again endanger the global economy, however we might hope that this will not be such an issue in 5-10 years if economic growth picks up. Additionally, the changing structure of the global economy and global oil demand may mean that economic growth can support a higher oil price. For instance, if the US becomes a net exporter then the world’s largest economy will benefit from these prices, and providing this money is invested in other economies as well high global growth could persist.

While a stronger USD will make oil purchases less attractive to holders of other currencies, with Eastern economies growing in size and other currencies growing in importance, oil transactions are more and more becoming priced in other currencies. Because of this changing macroeconomic backdrop, other currencies should become less inextricably linked to the USD and the weight of USD in total FX transactions (the USD currently is on one side of xx% of FX transactions) could decrease, with the currency also potentially losing its position of strength as the world’s preferred reserve currency. This may also reduce some of the downside risks to the oil price of a stronger USD.

With a dramatically changing global macroeconomic structure, and the geographies of global oil flows changing, there are therefore plenty of reasons to question whether the current relationship between the USD and the oil price will hold in the future. While these questions may not have such an impact on the short and medium term outlook for oil markets, we should take note of them for the long term direction of where oil is heading.