WTI No Longer Relevant For Crude Pricing?

Jim Brown
Printer Friendly Version

The broad disparity between the price of WTI Light Crude and Brent Crude has produced some serious questions about the relevance of WTI as the global benchmark for crude.

Brent crude traded over $103 this week and WTI has traded as low as $90. The maximum spread at any one time was more than $12 at one point. Historically they have traded in lock step with one only a dollar or so different from the other. Why the sudden change?

The problem is twofold. First the WTI contract calls for delivery to Cushing Oklahoma and the connection to the U.S. pipeline hub. Unfortunately once delivered there it can only be accessed by U.S. refineries. If demand is slow in the U.S. then supplies backup in the pipelines and require storage at Cushing until supplies in the pipe are consumed by a refinery and the oil can be uploaded to the pipeline. This is an extremely simplistic explanation but that is the bottom line.

When a trader wants to take advantage of a low priced front month contract and higher priced future contract (contango) he can buy oil for the current month, sell oil for a future month and arrange for storage at Cushing for the months in between.

The problem arises when there is no available storage at Cushing. If a trader can't find storage then he won't buy the oil and the trade evaporates. The higher storage levels are at Cushing the lower the buying interest for the current month contract. As the price declines a point is reached where traders can afford storage at an alternate location and a support point is formed.

A future month contract should equate to roughly the total of these factors. The cash price today + monthly storage rate + carrying costs and transaction costs. If the future price is higher than the total of these factors then traders will buy the short month and sell the long month. If the future month price is lower than the combination of those factors then traders will move on to something else and that exerts pressure on the front month contract.

Today the difference between the March contract ($90.85) and the June contract ($96.92) is right at $6 and a doable trade IF there was storage available. Unfortunately according to the EIA there were 38.3 million barrels in storage at Cushing out of a working of 40 million. The listed capacity at Cushing is 48 million barrels but they always keep some available for emergencies and it is commonly assumed the absolute maximum storage is 43 million. Oil is always arriving and leaving so they have to keep some working storage available to handle the routing and delivery functions.

With a working capacity at 40 million and current inventories at 38.3 million that does not leave much for speculators to work with. If there was an accident downstream from Cushing and they had to halt deliveries out of the Cushing inventory they need some surplus capacity for that kind of emergency.

Compounding this problem is the rising flows coming from Canada and the oil from the Bakken taking up refinery capacity and leaving more oil at Cushing. Transcanada Corp just completed a new arm of its Keystone pipeline to connect Cushing to the flow of crude from Alberta. That is going to be 150,000 bpd of new supply headed for Cushing.

This is going to increase the pressure on WTI as Cushing storage fills up and leave traders nowhere to turn. The problem will eventually be solved when Transcanada completes another pipeline to the Gulf of Mexico in 2013. This will relieve some of the inventory pressures at Cushing but that is two years away. That is a lifetime in the futures market.

With the Bakken ramping up from 350,000 bpd to 500,000 bpd over the next two years and Canadian oil sands production increasing the pressure on the WTI price is going to be immense. Odds are very good the spread between the Brent and WTI contracts will become even wider.

The Brent contract is primarily North Sea oil and unlike WTI it can be delivered anywhere in Europe. This makes the Brent contract a better indicator of oil prices because there are no storage problems to depress the price. It is a true supply - demand priced product. The majority of Brent is traded on the spot market by producers with virtually no formal term contracts. The name Brent came from Shell oil when they first began producing in the North Sea. They named all their different grades of oil after birds. Brent was named after the Brent Goose.

If you need more convincing the spread between WTI and Light Sweet Louisiana crude produced in the Gulf and deliverable in the Gulf was over $10 this week and at levels not seen since 1991.

When you see the price of "oil" quoted on CNBC or Bloomberg at $91 on Friday just remember that Brent and LSL are both over $100. Triple digit oil has returned but the public is living in blissful ignorance because of the storage problems for WTI forcing the prices lower. If it were not for Egypt I believe we would be seeing WTI under $85 today.

Until these problems are solved in 2013 the spread between the WTI and the real price of oil will continue to widen. Countries in Europe and Asia are paying prices indexed to the Brent price so the impact to their economy for energy consumption is already being felt.

A secondary problem to WTI being kicked to the curb as a global price index is the payment for oil in dollars. Countries and refiners have to pay for WTI in dollars. The purchase of dollars to pay for oil supports the price of the dollar. As the WTI falls out of favor for no longer being relevant the value of our dollars will decline. The price of Brent is already used as the index for two thirds of the world's deliverable crude supplies. Other grades price at a discount off Brent.

Don't kid yourself when you see WTI prices moving lower after Egypt blows over. The WTI price is no longer relevant.

Jim Brown

This newsletter is only one of the newsletters produced by OilSlick each day. The investment newsletter is also produced daily and contains the current play recommendations in the energy sector. Stocks, options and futures are featured. If you are not receiving the "Play Newsletter" please visit the subscribe link below to register.

Subscribe to Energy Picks Newsletter

See a list of our closed plays from 2010 here: Closed Positions

The OilSlick Newsletter is based on the expectations for global oil production to peak and begin to decline in the 2012-2014 timeframe. This is called "Peak Oil." This is the point where global production of conventional oil supplies can no longer be supplemented by enough oil sands production, deepwater oil production, biofuels and natural gas liquids to offset the decline in existing fields. The roughly 6% annual decline of existing production due to depletion is larger than the rate of new discoveries and new production being added each year. The Peak Oil countdown clock is ticking and time is growing short. Peak Oil is coming, are you prepared?