Tale of Two Contracts

Jim Brown
Printer Friendly Version

The U.S. light sweet crude contract (WTI) dropped to nearly $96 and more than a $3 loss intraday but rebounded slightly to close down only -$2.34. The Brent contract, which expires on Wednesday also dropped sharply but quickly rebounded to close positive once again at $118.84. This pushed the spread between the two contracts to a record $22. Why?

This is a really confusing time for the oil markets. The WTI contract is the most widely reported benchmark of crude prices in the U.S. but for the rest of the world the Brent contract is the key indicator. Europe and Asia buy oil indexed to Brent. Even the coastal refineries in the USA have to pay Brent prices for crude because imported oil is indexed to Brent.

Louisiana Light Sweet crude is an example. This is a light crude produced in the Gulf of Mexico and sold to refineries along the coast. On Monday LLS was just over $116 with Brent near $119. That was the first real divergence between Brent and LLS in quite a while. They normally trade together as the Reuters chart below illustrates.

Brent Crude Chart

Brent vs Louisiana Light Sweet Crude

Brent prices are being driven higher by shortages in planned cargos from the North Sea and from the loss of 1.4 million barrels per day of Libyan light crude. Also this week Shell declared force majeure on deliveries of Nigerian Bonny Light crude after rebels and thieves damaged pipelines and started fires that forced a shutdown of the system.

Light crude as represented by Brent is running short in Europe where EPA rules require refineries to process the highest grade possible to eliminate pollution. Add in the increased demand from Asia for light crude and Brent is not likely to go lower throughout the summer.

The crude oil Saudi Arabia has committed to supply in excess of their OPEC quotas will be heavy sour crude and most of it will go to China and Asia where there are refineries that can process that blend. Saudi's excess production will not help the shortage in light crude in Europe and Asia.

The Brent contract expires on Wednesday but Brent does not normally have the same expiration volatility as we see in the U.S. WTI futures.

There was no obvious reason for WTI prices to fall -$5 over the last two trading days. On Friday we could have pinned some fault on the USO rolling forward their July futures. They were scheduled to sell around 4,000 contracts of the July WTI on Friday. However total volume was around 380,000 contracts so their sales, while it would have produced downward pressure, would have been inconsequential in the bigger picture.

I speculated in another article that the sharp decline in the equity market and the quadruple options expiration this week may have forced traders to exit their long trades ahead of the weekend. The majority of options volatility normally occurs in the week before expiration. The six weeks of market declines may have pushed traders accounts to their pain threshold and dumping long futures contracts on a commodity that is not performing may have been a way to ease the pain.

Another problem is the slowing economy in the USA. Every day we get another series of economic reports suggesting the U.S. economy has taken a sudden turn for the worse. That suggests internal demand for WTI crude could decline.

At the same time the amount of crude flowing into Cushing Oklahoma and the delivery point for the WTI futures contract is increasing. Production from Canadian oil sands is increasing along with the production from the Bakken and several other liquids rich shale reserves like the Eagle Ford. The increased production from these various reserves may only account for 200-300,000 barrels per day over all of 2011 but Cushing is already out of space to allow for delivery. If refiners are not buying the oil then the system will backup and force an even stronger discount for WTI. There is a price where traders will buy physical WTI oil and transport it to the coast to benefit from the $20 higher price for coastal oil. They can move this by train or barge but the process is time consuming and expensive so the spread has to be wide to support the effort.

I have heard of prices being received by North Dakota producers in the low $80s for light crude because producers in North Dakota also have the same problem of transporting their oil to Cushing or to a pipeline that runs to Cushing. They are resorting to trains and several large producers are now building rail yards and contracting 100-car trains for the round trip as a way to get their oil to market.

Rather than take it all the way to Oklahoma they are sending some straight to the Midwest refiners at a steep discount and saving the transportation costs.

WTI Light Crude Chart

What is going to solve this problem? First, we need to quit referring to WTI as the price of oil. The WTI price is not relative to the real price of oil when the same oil is selling for $20 more per barrel several hundred miles farther south on the Gulf Coast. WTI is priced at a significant discount to reality because Cushing is landlocked in the middle of the country while the majority of the refiners are located on the coasts.

TransCanada Corp plans to build a $7 billion pipeline from Cushing to the Gulf Coast. The project has been under regulatory review since 2008. Once approved it will take 2-3 years to construct and that will allow Cushing WTI to be delivered to the coastal pipeline system and prices will again rise to match Brent. The pipeline will allow oil from Canada and all points south to flow through Cushing all the way to the Gulf. This will be a major improvement because oil sands production from Canada is expected to increase by 250-300,000 bpd over the next several years. By having access to the Gulf Coast that oil becomes more valuable. Today it is being discounted because of the oil glut in the Midwest.

Until the Keystone is completed we are going to see a continued disconnect between WTI and all other waterborne grades of crude oil. A waterborne crude like Brent or LLS can be sold anywhere in the world and therefore is reflective of the true global price.

WTI prices are going to continue lower as the glut of landlocked crude increases. However, as the shortage of light crude in the rest of the world increases we are likely to see Brent prices continue to rise. A rising Brent could cause a stabilization in WTI but until economic activity in the U.S. picks up to the point that refiners begin drawing down crude supplies I would not bet on it.

The REAL price of oil today is not $97 WTI but $119 Brent.

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 of light sweet crude to peak and begin to decline in the 2012-2013 timeframe. I am calling this "Peak Sweet™" instead of Peak Oil. This is the point where global production of conventional light sweet crude 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 Sweet™ countdown clock is ticking and time is growing short. Peak Oil will arrive shortly thereafter. Are you prepared?